Can clients get over the shame of defaulting on a mortgage?
Executives who improve a company’s bottom line by backing out of bad deals through strategic defaults on their commercial real estate loans often get bonuses. But when homeowners choose not to pay their mortgages because their homes have lost value, they are often vilified as deadbeats who are impeding the housing market recovery. Nevertheless, are there circumstances in which a financial advisor should recommend strategic default?
Executives who improve a company’s bottom line by backing out of bad deals through strategic defaults on their commercial real estate loans often get bonuses.
Some industry observers say yes. When the value of a property has fallen so much below what is owed that it would take years to recover the lost equity, it’s foolish to go deeper into debt to pay for it, according to Jon Maddux, CEO of YouWalkAway.com, a foreclosure company that charges a fee to help homeowners default. Rather, owners should use the laws to their advantage to forestall foreclosure while saving money to secure a better financial position in the future. James Surowiecki, a financial writer for The New Yorker, recently wrote that it’s time for owners who have no hope of recovering their losses to ignore the perceived stigma of default and do the “smart” thing rather than the “right” thing.
But deciding to default is not simple, easy or painless. For homeowners, ignoring the stigma can be difficult, says Lee Munson, the founder and chief investment officer of Portfolio LLC, an asset management firm in Albuquerque, N.M. He says that while companies “don’t write nasty letters” when another corporation reneges on a debt, neighbors often do become incensed when a homeowner does. They’re angry because foreclosures lower neighborhood home values; meanwhile, defaulters who stay in their homes while the foreclosure process drags on often get months – and sometimes years – of a mortgage-free ride.
Default is also disastrous to the borrower’s credit rating, often knocking 100 points or more off a FICO score, and the hit can take years to remedy. Moreover, defaulters may not be able to get a traditional loan again for as long as seven years afterward (though that may not matter if a client is wealthy and already owns several other homes).
The downsides of default are serious enough that owners shouldn’t do it if their home has lost value but isn’t actually under water, or if the borrower still has the ability to pay, Munson says. Yet that’s not always the case, he adds, so planners should take a “holistic view” when a client reveals that he wants to default. “The first thing a planner should ask is, ‘What situation is prompting the client to do this?'” he says.
Typically, the answer has something to do with a problem, such as job loss or divorce, which has become financially and emotionally overwhelming. Rather than call the lender to work out a deal, the distraught and embarrassed homeowner simply stops paying. Munson says that’s an avoidable mistake, since most banks are willing to work with an owner to avoid the expense of foreclosure. And after several recent pushes from the federal government, lenders are now more willing than they have been for several years to restructure loans on more friendly terms, or to agree to a short sale, he says.
EXCEPTION, NOT RULE
For similar reasons, John LaPann, president and chief investment officer of Boston-based Federal Street Advisors, says he would be “unlikely” to recommend that a client walk away from a mortgage under most circumstances. “The exceptions are few and would involve truly extraordinary situations,” he says. Among them are catastrophes that sharply reduce the value of a home and fall outside an owner’s insurance policy, and structural problems in a condominium that association members are unable or unwilling to cure.
But sometimes default just can’t be avoided. In those cases, it may make more financial sense to stay in the home while the case works its way through the foreclosure process rather than simply giving the bank the keys, especially if a lot of money is owed. A recent analysis by Lender Processing Services for The Wall Street Journal found that nationally, banks allowed homeowners with loans topping $1 million to stay in their homes for an average of about six months longer than those with loans less than $250,000. The wait is even longer in states where judges must approve foreclosures before banks repossess properties, such as New York, Florida and Connecticut.
If foreclosure is inevitable, Munson says it’s smart to hire a good real estate lawyer who can comb through documents for improprieties. Clients who have already gone through foreclosure should also hire counsel, since so many lender abuses have allegedly occurred over the past few years that compensation is being offered to consumers who can prove they were harmed.
Miami-based attorney Douglass Lodmell says legal help is important so clients don’t inadvertently give up any rights during the foreclosure process or get socked with a deficiency judgment that requires them to repay the defaulted amount later on. Before they get to the point where they stop paying the mortgage, clients with substantial assets other than their distressed home should also look into establishing protective trusts so that creditors “can’t just go in and grab them,” he says.
PAST THE PEAK
Although headlines predicted a tsunami of strategic defaults once housing prices began to fall, so far it hasn’t come to pass. Defining a strategic defaulter as someone who doesn’t pay the mortgage but does pay other non-housing debt, credit bureau Experian and consulting firm Oliver Wyman figured that strategic defaults peaked at about one in five foreclosures at the end of 2008. But such numbers are squishy because it’s impossible to know from the data whether someone can’t or just won’t pay debts. After all, even when a financial situation seems desperate, there may be other ways to raise funds, such as borrowing money from a friend or relative, raiding the kids’ college funds or taking a second job.
Borrowers are more likely to make the effort to keep paying if the amounts owed are relatively small; if they’ve amassed a large amount of equity in the home; or they expect the housing market to perk up soon, according to Michael Seiler, founder and director of the Institute for Behavioral and Experimental Real Estate at Old Dominion University in Norfolk, Va. They’re also highly influenced by what their peers do.
Seiler says that while most people denounce defaulters because it violates their deep-seated beliefs that we all should pay our bills, in a few cases the group-think works the other way. One woman he interviewed for his research said she had been paying the mortgage faithfully on her Florida home, even though her community’s home values had tumbled over the last few years. Yet many of her neighbors – who had defaulted – kept constant pressure on her to reverse her choice. “They talked to her as if she was an idiot to keep paying,” he says.
Lodmell contends that letting go of an underwater home allows the market to establish true prices and converts a bad “speculation-prone” loan into a good long-term asset. “It’s morally just to strategically default,” he declares.
But such attitudes are troubling to Seiler, who says strategic defaults create broader problems for society. He says it’s up to “mavens” like financial planners to guide their clients so that the interests of society, as well as individuals, are protected. “They can help cure the disease,” he says.
SOURCE: Financial Planning