Strategic Default and Bankruptcy – Where is Florida Headed?
The ongoing and systematic refusal by banks to enter meaningful loan modifications with homeowners will have long-term consequences that the average American cannot yet imagine. Just try to picture it…
Imagine your typical American family. Married couple, two kids. Earn $40,000 per year. Own a house worth $150,000 but owe $250,000. Have two cars, a small amount of savings/retirement money, and $10,000 in unsecured debt (credit cards). The numbers can vary, but you get the picture – your typical, middle-class family that’s making ends meat but not much else.
There’s a strong argument to be made, for such a couple, that it’s in their best interests to strategically default, i.e. stop paying on their mortgage, defend their ensuing foreclosure lawsuit, and file a bankruptcy (Chapter 7 or Chapter 13, depending on their circumstances). Each situation is different, but in all likelihood, this would drastically reduce or eliminate their credit card debts, drastically reduce or eliminate the deficiency on their mortgage (the $100,000 difference between what they owe on their home and what it’s worth), enable them to save money while their foreclosure case is pending, and give them a “fresh start” if/when the foreclosure is finalized.
For instance, suppose the foreclosure lawsuit were to take a year to conclude (a conservative estimate in light of recent reports out of Palm Beach that the average case takes 18 months), and their mortgage payment was $1,500 per month. With those figures, this couple would accumulate $18,000 in savings, merely by not paying their mortgage while the foreclosure lawsuit was pending ($1,500 x 12 = $18,000). If they completed a bankruptcy, they could keep this $18,000 if/when the foreclosure case was over. The $250,000 debt on the house? Poof – gone (or substantially reduced). The $10,000 in credit card debt? Poof – gone (or substantially reduced). Sure, this couple would lose their house, but what was the house really worth anyway? As I see it, and I suspect most accountants would agree, losing a house worth $150,000 when you owe $250,000 means you eliminated a $100,000 liability. Hence, the liabilities are gone, but the $18,000 – that’s the couple’s money to keep.
Now imagine the foreclosure case takes two years instead of one. Again, no way to know for sure, but given what I’m seeing in Florida, it’s certainly within the realm of possibilities. In that event, the couple would have $36,000 when the foreclosure lawsuit ends in two years. Think about that. $36,000 cash and little or no debt (depending on the type of bankruptcy), and all you had to do was defend your foreclosure case and file bankruptcy! And it’s all perfectly legal!
With this example in mind, who wouldn’t want to strategically default? I realize there are strong moral arguments not to do this, but let’s put aside morality for a moment and view this purely from a purely financial perspective. (That’s not terribly unreasonable, since that’s what the banks typically do.) Isn’t it clear this couple would be better off by strategically defaulting on their mortgage, defending the foreclosure lawsuit, and filing bankruptcy? In other words, isn’t it better to eliminate most or all of your debt, save up money, and have $18,000 or $36,000 or whatever amount in your pocket, and start fresh, than to owe $100,000 more on a house than it’s worth and credit card debt? Heck, in today’s economy, $18,000 or $36,000 (or whatever amount you were able to save) could buy you a house, free and clear. As such, it may be possible to convert your $250,000 mortgage into a free and clear house by doing nothing except strategically defaulting on your existing mortgage, filing bankruptcy, and retaining a competent foreclosure defense attorney to defend your foreclosure lawsuit.
Now the staggering thought – there are literally millions of Florida homeowners in this type of situation. Sure, there are plenty of Floridians who aren’t realistic candidates for bankruptcy because they have too many assets, too much income, or both. In today’s economy, though, such people seem to be few and far between. As such, what percentage of Florida homeowners could strategically default, stop paying their mortgage, file bankruptcy, and be better off? 40%? 50%? More?
Now, try to imagine what our country’s financial system will look like if this happens. Imagine half of all Floridians with a mortgage – or half of all Americans with a mortgage – go into default. If that happens, what will our financial sector look like? Will big banks even exist? What will property values fall to? What will our court systems look like? These are staggering questions for which there is no clear answer.
Now a tough question – should the typical Florida homeowner care? In other words, to what extent should homeowners continue paying their mortgages for the “good of society,” even to their own detriment? Undoubtedly, there are arguments to be made on both sides of this issue as well. Given society’s “me first” attitude, though, I’m confident many people will disregard the impact on society and embark on this path. Hence:
As things now stand, millions of homeowners will choose a strategic default.
Avoiding this consequence should be the primary objective of the U.S. government. Quite simply, our government must step in and do something to ensure that everyone doesn’t have the incentive to strategically default. Our economy and financial sector as a whole will not be able to function if so many Americans have the incentive to stop paying.
How does one go about this? The problem, in my eyes, goes back to the absence of meaningful loan modifications. People have the incentive to default because they see that a bankruptcy court would eliminate or reduce their debt and nobody else, i.e. the banks, is willing to do so. Using the example above, if the banks reduced the mortgage to $150,000 or even $175,000, maybe that homeowner would have some incentive to keep paying. Suffice it to say that to fix this looming crisis the government must implement some type of loan modification program that will work on a massive, widespread level. Absent that, our country is headed down a path of “stop paying, file bankruptcy, defend the foreclosure, and come out on the back end far better off.”
Posted in Main | 39 Comments »
