The Principal Solution to Strategic Walk-Aways

There’s been a lot of discussion on the subject of Strategic Default over the last year or so, with no shortage of passionate viewpoints.  It’s a favorite topic in all forms of media.  The last time we posted an article on this subject (Feb ’10) it created a virtual firestorm of response.

Ethical and legal arguments aside, it’s always been our opinion that the most practical solution to this issue is for lenders to reduce principal loan amounts.  If you can make payments on a $350K loan but the home is only worth $200K, then does it make sense for your lender to reduce your principal to match the fair market value of your home?  Yes, and here’s why:

  1. If you don’t have a “hardship,” you only have two options: take your lumps or walk away.  You don’t qualify for a loan modification or a short sale.
  2. You likely chose your home for the lifestyle it offered, rather than as an investmentYou would be content to stay if you didn’t feel like the value was a total loss.
  3. Lenders (and their investors) prefer performing loans to non-performing loans, and it’s well-documented how costly walk-away defaults are for lenders.
  4. Governments like performing loans, too, but their solutions aren’t working.

A principal reduction modification could even be an equity-share agreement.  The borrower agrees to share any equity growth with the lender at the time of sale.   It’s a no-lose proposition.  Sound improbable?  Well, it’s already happening.

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A close friend very recently received such an offer.  It came in an overnight express package directly from the lender, a major bank, with a no-strings offer to reduce the principal loan balance by a substantial amount.  After a lot of “must be a scam” follow-up, it turned out to be legit. Now the loan balance is lower than, or near market value.  The borrower can consider new options: stay and make improvements, or even sell without a loss.

The property in question had lost over 35% value since purchase, and was worth considerably less than the loan balance.  The payments were much higher than comparable rent.  Numerous attempts at loan modification failed because there was no hardship.  The borrower could still easily afford the payments, and loved the house, but was seriously considering walking away.  Seemed like a sound business decision.  Nonetheless, they continued to stick it out.  After about a year, a new lender acquired the loan, and almost immediately they offered the principal reduction.

Some suggest that there is no such thing as “doing the right thing.” Compared to what?  Nevertheless, my friend was rewarded for being faithful and credible.  Everybody wins.  No legal consequences, no ethical dilemma, lifestyle intact, the loan doesn’t default and the bank doesn’t have to dig the occupants out.

There are some prerequisites to qualify for this offer.   I can’t verify this, but from what I understand you have to be current with your payments and it applies only for purchase money, not cash-out refi’s.

This is definitely more the exception than the rule, at least so far, but I expect we’ll see more of this.  There is hope for those you who are hanging in there, and there is still some good old-fashioned common sense afoot in the land of “I, me-me, mine.”

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The Ethical Dilemma of Strategic Walk-Aways

Owners that can actually make their loan payments, but choose to walk away, accounted for 1 in 4, or 25% of all foreclosures as of June 2009.   That was over six months ago, and the numbers have probably gone up since the initial studies (these data can be easily verified via a quick Google search).  Strategic default is an ethical dilemma, and the discussion is burning up cyberspace. On one hand, there is a moral obligation to honor your contract.  If you owe more than your house is worth, one way or other you gambled on your equity and came up short.  Maybe you bought at the top of the market, or took out an equity line of credit and bought some stuff; a car or TV, or maybe even another house.  Regardless, it’s not your lender’s fault that your property value went down.  After all, if your property went up in value you wouldn’t turn around and give the bank extra, right?  If you buy gold, and it loses value, you don’t get your money back, you wait it out. If you loan money to a friend, and he loses it all, you would still expect him to pay you back, especially if he can afford it.  The value of a promise doesn’t flex due to circumstances, or whether you are the giver or the receiver.  If you can make your house payments, it’s the right thing to do. On the other hand, are the banks responsible for some of this mess?  Should they share the burden? Didn’t they sort of tease us into all these high-risk loans and credit cards?  In the first few years of the Y2K decade, the FED, major lenders, and real estate professionals convinced us that everybody in America could buy a home.  They made you feel foolish if you didn’t.  It was like manifest destiny,your birthright, your duty. You could get a home loan if you had a pulse.  You could qualify just because you said so, no matter if you could actually afford one. Lenders didn’t seem to care if you were truthful in your loan application.  Certainly they knew they were making questionable loans, gambling on equity just like us.  Aren’t the financial institutions culpable, too?  Didn’t they practically beg us into this? The survival of our economy depends on everybody doing the right thing.  Imagine the consequences if all borrowers that owe more than their house is worth but can afford the payments choose to walk away, or if all the lenders call in all the notes on properties that won’t appraise for the full amount.

So, who gets the free morality pass?  Who gets to choose what’s fair? Is personal credibility negotiable?   Is the golden rule irrelevant?  Do we just step off when times get tough? Is this the new American paradigm? Not surprisingly, real estate professionals are leading the charge in advising people to walk away.   Not ironically, real estate professionals were leading the charge 4-6 years ago advising people take on these same loans.  Whatever it takes to earn a fee.  Maybe it’s time for an industry gut check.

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