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“Strategic Defaulting” on Loans: What do you think?

posted by Scot McKnight

We don’t often enter into the business side of life or discuss loans and mortgages and foreclosures and bankruptcy, but this article — HT: RJS — suggests to me that there is something to be discussed here and we need some financial folks to speak up. The issue is that many people today are “strategically” deciding to default on their loans; they are “shrewdly deciding” that defaulting and going belly up will help their financial situation. What do you think? Is this wrong? Or this is just shrewd? 

So, here’s a clip from a recent article in the NYTimes:

And given that nearly a quarter of mortgages are underwater, and that 10 percent of mortgages are delinquent, White, of the University of Arizona, is surprised that more people haven’t walked. He thinks the desire to avoid shame is a factor, as are overblown fears of harm to credit ratings. Probably, homeowners also labor under a delusion that their homes will quickly return to value. White has argued that the government should stop perpetuating default “scare stories” and, indeed, should encourage borrowers to default when it’s in their economic interest. This would correct a prevailing imbalance: homeowners operate under a “powerful moral constraint” while lenders are busily trying to maximize profits. More important, it might get the system unstuck. If lenders feared an avalanche of strategic defaults, they would have an incentive to renegotiate loan terms. In theory, this could produce a wave of loan modifications – the very goal the Treasury has been pursuing to end the crisis.

No one says defaulting on a contract is pretty or that, in a perfectly functioning society, defaults would be the rule. But to put the onus for restraint on ordinary homeowners seems rather strange. If the Mortgage Bankers Association is against defaults, its members, presumably the experts in such matters, might take better care not to lend people more than their homes are worth.



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RJS

posted January 11, 2010 at 2:32 pm


What struck me in this article is the difference in ethics.
If a business defaults on a loan in such a condition – cutting the losses – it is just good business practice. The business (or the CEO) is not considered morally deficient.
Yet for an individual – it carries a moral cost. As individuals we tend to think we should honor our commitments.
Fascinating article. Is default and surrender of the property just good business practice for an individual as well?



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dopderbeck

posted January 11, 2010 at 2:54 pm


A basic principle underlying the common law of contracts is the notion of “efficient breach.” In general, the damages for breach of contract are entirely economic, and are intended only to put the non-breaching party into the same economic position it would have occupied but for the breach — there are no punitive damages. Often, in economic terms, it is better for all the parties, and for social welfare in general, for a party to breach and pay damages than for the contract to be fully performed.
For example, say A has a contract to sell 100 widgets to B for $100. Before A delivers to B, C offers to buy the widgets from A for $110. A sells to C, and B procures a replacement supply of widgets for $105. A will be required to pay $5 in damages to B, placing B in the same position it would have been in but for the breach; but at the same time, A has made an additional $5, and A’s widgets have been allocated to a more highly valued use.
There are other theories of contract, particularly grounded in the morality of promises, that criticize efficient breach theory. Nevertheless, the law favors efficient breach theory, as evidenced by the severe limitations imposed on “penalty” provisions in contracts.
Long and short: a mortgage contract anticipates the possibility of default by granting the mortgagee an interest in the real estate being financed. The mortgagee decides whether or not to grant the loan based on its underwriting calculations. Both parties incur risk, the risk is hedged by the mortgagee’s interest in the property, and the possibility of default is part of the basis of the agreement. Under these circumstances, I’m not sure it’s always morally more noble for the mortgagor to bear the full costs of a market downturn.



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Bob Young

posted January 11, 2010 at 3:30 pm


Regardless of whether you’re a company or individual, lender or lendee, regardless of contract law, case histories, etc…. isn’t the real question “how should citizens of the kingdom of God deal with one another regarding debt?”
Forget what the world does, what do Moses, Jesus, Paul, etc recommend? My understanding is that if you can pay the debt, then by all means pay it promptly. If you are the lender, then you deal with the risks of lending. Money is a great magnifying glass for the heart…



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T

posted January 11, 2010 at 3:32 pm


On a personal note, I have a close friend who is considering bankruptcy this month. (He would qualify for the ‘discharge’ variety.) He may or may not have his mortgage as part of it. He is a former pastor and feels this acutely. He went into business last year to make custom t-shirts and opened a line of credit (personally, though for the business) to purchase the initial equipment and to handle monthly cash flow issues. His credit has always been excellent. The equipment (over ten thousand dollars) never worked right and the problems and related expenses killed the business in a matter of months. Even though he was still in debt for the line, he was able to scrape by and make all his payments from other work. Then the bank decided to substantially increase the minimum payments, which he could not make. The failure to make the payments increased the interest rates to shocking amounts, and now the total is rising faster than he can pay.
He has asked his friends for prayer and counsel as he considers bankruptcy, which he is loathe to do, but he does not have income or assets to pay the debt. I realize we are called to “pay everyone what we owe them” but I also realize that our bankruptcy code was at least initially a form of structural mercy for citizens that was inspired at least in part by similar provisions in the mosaic law. Are Christians never to ask for this relief that we have put in our legal code, inspired by biblical examples and priorities? I don’t think bankruptcy is something we should enter without a care in the world, but I think the typical Christian aversion may be too strong.
Scot, David (anybody!), any good studies or writings on bankruptcy & the Christian?



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Linda Hurry

posted January 11, 2010 at 4:12 pm


I am quite surprised by some of these responses, as well as the article itself. Except for the small minority of borrowers who were cheated by unscrupulous lenders, you went to the lender and told them I really want this house and I want you to buy it for me. Or, I already have this house and I want you to give me, either better terms, or more cash. Appraisals were done, based on the value at that time. You signed promises to pay that money. Money, yes, real cash money, was either given to you or the person you bought the house from. Real cash money was taken out of a bank, or an investor’s pocket,etc. Real people, real money. Now, even though you could pay, you don’t want to because the value has declined. It’s not the first time, it won’t be the last. Unless you are otherwise unable to provide for your basic needs (not wants – not a fancy car, designer clothes, restaurant meals, etc), you have an obligation to keep making the payments. You wanted to pay the amount you paid, or you wanted to take the cash out you took out. Why should the shareholders of the bank suffer because you thought it would never go down? Each one of those defaults makes borrowing a little more difficult for the rest of us. If the loan was guaranteed by the government, that’s tax dollars from my pocket. Let your yes be yes and your no be no.



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Darryl

posted January 11, 2010 at 4:56 pm


My father was a small business owner. He had customers who owed him money and when they went bankrupt he was stuck holding the bill. Our family was hurt due to someone else’s inability to honor their contractual obligations.
Forget legalities. As one poster said: what is Jesus’ response? What is the Christ-like spirit? While Jesus would say “lend expecting nothing in return” he says that to the person who would lend, not to the person who is borrowing!I would think to the borrower he would say something like: “Blessed is he who keeps his oath even when it hurts” (Psalm 15). When a bank loses money, someone gets fired–downsizing occurs. So, my default on a loan may cost a breadwinner his or her job.
Another ethical consideration: the golden rule in the Sermon on the Mount. How does treating others (even big bad money grubbing lenders) they way you want to be treated fit in with this issue?



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ChrisB

posted January 11, 2010 at 5:30 pm


There is a great big moral difference between the person who can no longer pay his debts and the one who decides his house is no longer a good investment for him.



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Bill

posted January 11, 2010 at 5:39 pm


Are we to treat commercial lenders (legal corporations) as if they were persons, with a soul that teeters between heaven and hell? Aren’t corporations simply a legal construct to insulate the owners from financial liability, to prevent their personal assets from being attached due to poor decisions made by the corporation (like lending to someone who isn’t qualified?)
It seems to me that we are taking Scriptures clearly aimed at relations between human persons (having souls), and applying them to relations to corporate entities with no soul whatsoever, and no God-informed conscience, either.



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Your Name

posted January 11, 2010 at 6:53 pm


The full article presented a more thorough discussion. Some of the points were:
- Both sides made a deal. If you stop paying, the bank gets the house. You aren’t avoiding the consequences, you are suffering them, exactly per the agreement.
- Banks don’t hold the paper, it is sold within days or hours to investors. If you think “putting your local bank teller or loan specialist” out of a job as a rationale for paying, the banks already cut those positions when the mortgage brokering business dried up 2 years ago.
When Wall Street began securitizing home mortgages, they paid a decent rate of return and had little risk, because the loans were written under the old rules: 20% down, sparkling credit, stable job, and the banks owned the paper on houses in their neighborhood. After 2003 or so, most everyone creditworthy had re-fi’d their loans. Wall Street cranked up the machine and bubbled it up.
- Banks and brokers had every reason to push loans on unqualified people on overpriced houses in overheated markets with risky terms for them (no money down, marginal or no credit).
- To the person who said “Why should the shareholders of the bank suffer because you thought it would never go down?”, I would ask in return, “Why should the shareholders of the bank not hold their management accountable for violating the lending rules (minimum down payments, credit history, proper valuation, acceptance of risk by holding the loan) that had made housing a sure but slow bet for both the banks and the homeowner for a generation?”
I don’t like the idea of people walking away from their loan if they are a bit underwater, if they can pay (even if they have to struggle). But for those who owe $400,000 on a house now worth $200,000 just 2 years later, I can see walking away as the best thing to do.



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Bob Arnet

posted January 11, 2010 at 7:20 pm


I have to agree with Linda Hurry’s comments regarding paying back a loan that you agreed to pay back in the contract. If everyone walks away from a loan they could pay back, but just don’t want to because the value of the home is diminished, the rest of us will ultimately be paying one way or another. I’m not feeling sorry for lenders who gave out loans to people that they couldn’t afford. I’m just saying that those of us who pay our bills will somehow be absorbing the costs of so many people walking away from their mortgages.
It’s like the stock market; you only realize a loss if you sell it now. The market will come back.



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RonMcK

posted January 11, 2010 at 10:03 pm


My grandfather died during a serious drought, just as the 1930s depression was getting under way. My grandmother was left to raise a young family on her own, while managing a farm that had been bought for too high a price a few years earlier during the post-war land boom.
The Labour Government in NZ passed a Mortgage Relief Act. This act was administered by committees, which had the power to wipe off the debt of unpaid interest and rent, and to reduce the value on the outstanding mortgage. There were cases of mortgages being reduced by two thirds.
When my Dad (in his teens) suggested to my grandmother that she should put in for Mortgage Relief. She didn?t even discuss it but said, ?What we have contracted to do we will do?.
My Dad was amazed how quickly she paid the mortgages off and had a farm clear of debt. He wrote many years later, ?Many of those who had big debts wiped off did not prosper as families. Other factors in their lives seemed to knock them back, while my grandmother, who was determined to honestly pay her debts, had a family who in many ways appeared to be better off.
Maybe there are principles that we need to live by if we expect to prosper.?
Legality and morality are not always the same.



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Your Name

posted January 12, 2010 at 9:38 am


This is a topic that hits close to home for me. I work for Bank of America in liquidating their foreclosed assets throughout the country.
In addition, I have also known many close family members and friends in the last couple years who live in one of the cities in America that was hardest hit by real estate crisis and they faced this very situation. Most of them are Jesus loving people who desire to do the right thing.
The personal stories I hear from people every day as I see firsthand the foreclosure mess cleaned up are often tragic. People who worked and saved for a long time to be able to afford a 3 bedroom 2 bath 1600 sqft. For $300K only to see that home now selling for $120K. What do you do? If you look at the amortization schedule on a loan like this it would require the person with a $300K loan to pay for over 20 years before even getting to the breakeven point and market value for their asset.
And I use the word asset intentionally. As a nation we have made a powerful shift away from viewing houses as homes, but instead they are seen as commodities or investing tools. We as a nation are way more transit than we have ever been and we are always looking to move on to some where else or to a bigger home.
As a follower of Jesus I do understand the integrity dynamic in all of this and that we should do all that we can to keep our word. Yet after all I see I am left wondering what happens when the banks, politicians, builders, investors, and neighbors do not and it so devastatingly effects you? I am not claiming to have all the answers here but I will say that from a insider?s perspective the banks still have a long way to go in liquidating many of these foreclosed process.
Last I will say that many of us find it interesting that the two states with absolutely no increase in foreclosures in the real estate collapse are Nebraska and North Dakota. This has been a strong testimony to an traditional mindset toward money, only buying what you can afford, and hard work.



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Dave Briggs

posted January 12, 2010 at 10:59 am


We often ask the wrong question. The question is not, “What is the most personally advantageous thing to do?? ? the question is, ?What is the right thing to do?? What conclusion would we reach if we looked at this with a ?godly mindset??
Complicating the issue is a tug of war between the ?micro? and the ?macro.? The micro is concerned with the individual, the macro with the larger group implications. We can get all emotionally involved with a specific hardship example on the micro level and miss the larger, and more important, issue at the macro level.
At the macro level our whole economic system rests on the basis of trust. We only take little green pieces of paper in exchange for our work become we have trust in the system and the ability to exchange them. When we sign for a mortgage and break the ?trust barrier? by simply deciding not to fulfill our promise ? that break in trust begins to dangerously erode the entire system that we all depend on for basic economic exchange.
When you promise to pay back what you borrow ? you have an obligation to do everything possible to meet that obligation, even if it puts you at a financial disadvantage.



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Diane

posted January 12, 2010 at 1:29 pm


Number 12–your name
Thank you for the moving story.



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