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Bankruptcy, Foreclosures, Loan Modifications and Ethics

by Andrew on November 27, 2009

It has been a surprise to see the number of comments on this blog that have revolved around the issue of ethics in mortgages and loan modifications. A pleasant surprise, but a surprise nonetheless. It is the single most popular controversy.

Are easy roll-over Bankruptcies morally wrong?

When should someone default on their mortgage payments if he is unemployed and with an underwater mortgage but still has cash in his bank account?

How easy should banks make it for clients to get loan modifications, or how “troubled” should homeowners be before they “deserve” them?

And, finally, what is probably the queen of controversy in the mortgage world. Should the government bailout homeowners that can’t afford their mortgage or simply let the natural market forces do their job?

I doubt any two people would agree on all those issues which is what makes ethics and mortgages such a controversial issue. What makes it even closer to the heart of all of us is that mortgages deal with homes, a basic need for our families and symbol of our identity.

Benjamin, from the http://thephoenixrealestateguide.com for example, commented that mortgages are simple contracts and that much of the ethical issues built around mortgages and bankruptcy exist only in our minds. The comment was a reply to a rather angry man that disagreed with the advice another reader was offering to underwater borrowers to call it a day and strategically foreclose and declare bankruptcy to get a fresh start. This is his comment with some very gentle editing:

It’s hard to argue the ethics of making such a decision.  The fact is that when someone buys a home, they enter into a contract.  If they pay the mortgage, they get to stay in the nice home.  If they don’t pay the mortgage, they lose the house.  Those are the rules.  The bank agreed to them and the homeowner agreed to them.  If everybody agreed to them at the time of purchase, then a strategic foreclosure or default is still playing within the established rules.
Morals have nothing to do with it in my opinion. It is black and white. Imagine you rent a movie a movie from redbox. You spend $1 and enter into a contract to rent the movie for a night.
You decide to keep it for a week instead.  Redbox will charge you for every night you keep it.  It was in the contract that you originally agreed to. Walking away is simply a tool in the tool box.

I am not sure about the Redbox illustration, it would seem to me that those that are strategically foreclosing a mortgage and then declaring bankruptcy would be more like someone who rents a movie with Redbox never takes it back and cancels the credit card they used, when asked to pay for the rental sells the DVD on the second market and gives whatever he gets to Redbox.

Nevertheless the point is in my opinion well made. If foreclosure is an agreed consequence to not paying your mortgage then there is no moral issue. The bank knew it was a possibility when it agreed to provide the loan. I think most people would agree with that.

However the issue, as I see it is more to do with the effects of bankruptcies caused by foreclosures on unprotected (i.e. with no collateral) loans, and if this is fair. Our view of bankruptcies has changed through the years. In the middle ages up to the 18th century prisons were mainly for criminals waiting to be banished or executed and for people who couldn’t pay their debts.

Today we generally don’t feel debtors deserve prison unless they commit fraud. However bankruptcy has kept much of its stigma, associated with dishonest and untrustworthy people. This has changed with time, bankruptcy becoming in many cases a logical financial tool to be used when things go wrong. Some would argue that it has become too easy to “get out” of debt while yet others would point out that current bankruptcy rules are stringent enough to make it a final resort few are happy to enter.

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  • I agree with this post. Putting aside the discussions on the legal and moral considerations of strategic defaults is the huge societal change that is taking place by this entire predicament. We are lowering the bar on what is acceptable for foreclosure and bankruptcy. The decades upon decades of balance between breaching contracts and the stigma of breaching contracts has unbalanced and this will impact society for decades to come.

    Personally, I have not been a big fan of loan mods, not because it is not a good idea but because most did not make a lot of sense for the amount of loss in value. If lenders and contract owners of the loans acted more responsibly in these loan modifications they would not have "trained" society on walking from homes. These crisis is everyone's crisis, not just the borrower and not just the contract owner. We all know their is a "sweet spot" of modifying a loan that the borrower will not default and the contract owner will minimize their loss.

    Until that happens, we are on the disastrous path of training masses in society that foreclosure and bankruptcy is ok and our neighbors are no longer gasping with hands over their mouths that their neighbor was foreclosed on or had to file bankruptcy. It is becoming more acceptable. No question, very bad for society as any recovery will be prolonged by such sentiment.

    A prediction of sorts... 2010 will see a dramatic increase in strategic defaults which will result in the bankruptcy laws being changed to allow judges to cram down mortgages which will lead to contract owners allowing servicers to modify loans more aggressively and then our market will begin to stabilize. Then the healing can begin on society's attitude towards foreclosure and bankruptcy.
  • I agree with your stance on loan modifications. When I am talking with someone about their options, I need to know how long they are planning on staying in their home. If it is more then 10 years, it might be worth a doing a modification. If they are going to be moving anytime before then, a loan modification doesn't make sense. It would be smarter to do a short sale, rent a few years, and buy again while prices will (most likely) still be low.

    If someone owes $250k on a home that is now worth $125k (very common here in AZ) it would take 15 years at 5% appreciation every year to get to $259k.
  • I agree... The redbox analogy was terrible (I was in a hurry?)

    Anyway, so my stance is clear, if it were up to me the free market would have taken care of this whole mess. But if there was a free market, we probably wouldn't have gotten in to this mess. My point is that it is easy to say we should or should not allow this or that. But it's not my families future at stake. It's not MY kids college funds being wiped out. I'm not 60 years, 5 years from retirement, and watching my the last of my 401k being wasted while I'm hoping the market will turn around.

    As a real life example, there is a guy in our office that helps people get loan modifications. His personal story is an example we use all the time. He had a home that he bought 4 years ago for $1.8mil. He owed $1.4mil on it and when he decided to work on a modification (lost his job) it was worth about $600k. He did not make a mortgage payment for 15 months before the bank agreed to a loan modification. His payment went from around $7000 to just under $2000. All the money he would have used for the mortgage went to other debts so he could stay current. He never touched his retirement accounts. His neighbor was in a very similar situation. Owed about $1.6 it was worth about $700k. He was also out of work. He stayed current on his mortgage, pulling money from savings. When he finally got his modification (after over a year of trying) his payment only dropped to about $5000 and his savings were almost wiped out. So did better for their family? Both played within the rules. One had an extra $100k at the end of the day to keep current with other debts, still had his savings, and a $2000 mortgage. The other wiped out his savings and fell into more debt trying to stay current with his mortgage. And his payment is more then 2x the amount of the other.
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