Strategic Mortgage
Posted January 8th, 2010 in Real Estate, Sharing the Experience | 
The Promise
Being honest in your business dealings and with your friends used to mean something. There was a time when it was a signal of trust and resposibility. I’d like to think it still does but, sometimes you really wonder just how thin the paper is.
I like a good solid handshake. You can find out a lot of things with a hand shake. It can tell you that the other person is confident and usually forthright in their dealings. Sometimes, it tells you other things that serve as a warning. A handshake used to mean something but, I’m not sure it carries the same level of honor it used to. Some people shake your hand and you can’t tell what the message is – it is like shaking hands with gloves on. In some circles handshakes have been replaced by hugs. I suppose hugs are good things but, at times I’m not sure what the intended message is either – it can be confusing!
Then there is the kiss on one or both cheeks. This always bothered me when you consider all the virus’ and bugs flowing around this world. It’s still a proper social greeting in many countries and is probably very meaningful in some deep rooted way but I think a portable scanner may soon be required. The bow from the waste seems less hands on.
Till Death Do Us Part
Being married also used to mean something. Looking at the statistics you would think that this commitment has less value than trading in your 7 year old car.
For some time we’ve seen a lot of things that reflect this lack of honesty, integrity, commitment and willingness to keep a promise. You might call it being irresponsible others call it having an excuse.
You will find many that are obvious. Elected officials are an easy target when you look at how they dance before the vote is cast and after. Public projects such as the one that has 5 rings attached to it don’t seem much different. There’s a kind of ‘awe shucks we didn’t think it would cost that much’ persona about it all. Sadly, they are not alone.
Who Cares? – They Do It!
The idea of buying a house and paying it off with the idea of actually owning it one day used to mean something as well. That idea of responsibility to your commitment, explored within this article from the New York Times Walking Away From Your Mortgage, seems also to have gone by the wayside.
A while back you may have signed a mortgage document. In effect, you made a promise and in signing you accepted the responsibility to fulfill that promise. Simply that mortgage document reads something along the line of if you lend me the money to buy this house I promise to pay back the principal owed and the interest you charge me for the privilege of borrowing your money.
Roger Lowenstein, the writer, points to “the rising number of folks who are voluntarily choosing not to pay” claiming that “such voluntary defaults are a new phenomenon” because, as he states, “some of them are making a calculated decision to hang onto their money and let their homes go.” It seems this is a learned tactic from various big corporations which Lowenstein refers to in his article.
Lowestein notes, that while “mortgage holders do sign a promissory note, which is a promise to pay. The contract explicitly details the penalty for nonpayment — surrender of the property. The borrower isn’t escaping the consequences; he is suffering them.”
It is called a “strategic default”!
The Banks Know
It’s an interesting development that has been discussed in two or more papers. Filtered, a ‘strategic defaut’ then, is that choice made by borrowers who can afford their mortgage payments but make a calculated business-like decision. They stop paying when the value of the home is equal to or less than the value of the outstanding mortgage.
For some interesting and intense reading on this topic with alternate analysis on the process of this phenomenon look to A Structured Approach to Stress Testing Residential Mortgage Portfolios by Tim Hampton and Ian Harrison and An Option Pricing Approach to Stress-testing the Canadian Mortgage Portfolio by Moez Souissi.
In the hope of understanding this new thing called a strategic default, a once over of these papers added a dimension to the meaning of words such as promise, accountability, commitment and responsibility. The take away was that now embedded in the meaning of those words is a self serving financial decision.
Curiosity remains to ask what is your interpretation?
Thinking of Buying or Selling your Vancouver home? Put on a cup of coffee and let’s talk.
Futher opinion: Elli Davis Team
Good post Larry.
The prescribed “penalty for non-payment” was never intended to be interpreted as an option under a mortgage agreement, but we humans are funny beings and we’re skilled at finding justifications for acting in our own best interests.
The ‘strategic default feature’ is one seen before in Canada – we just forget! I fret about the zero down to 5%’rs and the 40 year amortizations. These are the most ‘at risk’ group.
Lunch with a Banker helped to put it in perspective. He recalled how in the 80′s as a manager in Alberta it was not uncommon for clients to enter his office, drop their house keys on his desk and walk out.
Before leaving some had a few not so kind words while others were in tears. He had hoped he would never experience that again but did offer that Alberta was at that time a debtors Paradise. He summed up their conversation something like this – “We don’t want to fulfill our contractual obligation – here’s your security! Have a great day!”
BTW I’m checking into it but I don’t think it’s much different here in B.C.
An sidebar is that his lending institution had mortgages on many homes in new developments. The result was not unlike what we see in some cities south of the 49th. During this time they had to start a new House Maintenance department with crews that did nothing but maintain the vacant homes until they could be resold.
My hope is that we don’t see that reality again but, you never know!
II am a regular follower of Norm’s Saskatoon RE blog, and followed him here. While I think we are in agreement on many things in life re: principles and honor, I have to disagree with him on this one.
All lending contracts are held by two parties. I ask you for money, and you get to decide whether or not to give it to me. Each side has a responsibility — both to themselves, and to the other party.
- The recipient’s self-responsibility is to report honestly all financial factors, including credit history, income, assets, liabilities, etc.
- The lender’s self-responsibility is to ensure that their capital is covered, or at least recoverable. If there is risk involved in the transaction, then that risk must be priced into the contract.
On this basis, both parties get to decide whether or not they want to enter into the contract. Nobody can force a lender to lend; if they think that someone is a bad risk, or likely not to repay, then their correct decision is to either hike the risk premium significantly to cover that, or refuse to lend. The recipient can look at the terms and decide if they want to accept them, reduce their request, or seek out another source.
The lender’s analysis MUST come in front of the deal; they have to look at all information provided and determine what a reasonable risk is and how to price it in. They have to look at market conditions and long-term trends. That’s why they hire all the smart guys as statisticians and actuaries. They also (should) have all the financial information they need to determine whether or not the loan will ‘perform’ — that is to say, whether or not the recipient will be able to pay it back. (Which is why, if that info is misrepresented, the person doing so is committing a criminal act and SHOULD face criminal consequences.)
ONCE THE CONTRACT IS ENTERED, each party has external responsibilities:
- The recipient is responsible for making the agreed-on payments.
- The lender is responsible for accepting and maintaining the terms of the agreement, and not changing them in the middle. (“Hey, Joe, the bank had a bad quarter. We need you to make an extra mortgage payment this month…”)
If either side fails to live up to the contract, there are written penalties: the lender is liable for breach of contract, and could be taken to court (or tried in the media). The lendee loses the security that they put down against the loan, and loses their reputation as a sound borrower (aka ‘trashes their credit rating’). If there is no security — i.e. in the case of most credit card debt — then it is very difficult for the lender to make recovery… which, incidentally, is one of the reasons why credit card balances carry such a hefty interest rate. This is their risk premium.
This is the way money lending goes — whether it’s for a vacation, a washing machine, a car, a small business… or a house. So what happened with mortgages?
1) Bad business model. “RE always goes up.” That means that even if an individual can’t pay, the assumed recovery rate will be high. Mistake – bank.
2) Poor (or no) risk premiums. I have a spotless credit record going back 20 years, and I own 50% of my home. Yet when I go to get a mortgage, my rate is exactly the same as the young guy buying new house with 5% down. Oh sure, he pays a little more in CMHC insurance, but most banks will just ‘roll that in’ to the mortgage. So all recipients are treated approximately the same… even when they are not. Mistake – bank.
As I said, the lender’s analysis must come before the loan is made… but the recipient’s analysis comes after. They are obligated to live up to the contract (just as the lender is), OR FACE THE CONSEQUENCES. That’s what contract law is about. Furthermore, it’s the banks that write the contracts; all we do is ‘sign on the bottom line’ so one would assume that the banks would protect themselves within the strictures of said contract. If they did not provide sufficient protection… why is it my job to cover their deficiency?
To norm, I have to ask these questions in response to your statements:
“The prescribed “penalty for non-payment” was never intended to be interpreted as an option under a mortgage agreement”
… no? Then what was it in there for? And what *was* it ‘intended’ as?
“but we humans are … skilled at finding justifications for acting in our own best interests.”
Of course it’s my job to act in my own best interest, and that of my family! Who else should I be abrogating the responsibility to… the bank? Should I trust that their desire to see me continue making my mortgage payment regardless of what other hardships or stress it may cause is solely because they care about *me*? Really?
A mortgage is a contract. The only difference is, it’s the biggest contract that most of us will ever enter, and it has emotional bonds attached to it … on our side. There are no such emotional bonds attached on the side of the bank, are there? They are treating it in all aspects like a business arrangement, so why shouldn’t I?