How to Think About: Underwater Mortgages

Real estate prices have dropped about 30 percent since their peak in 2006. As a result, something like ten million American homeowners owe the bank more than their houses are now worth. More than half of them are stuck with mortgages that are more than 20 percent higher than the value of their homes. They could simply walk away from the home, stop paying the mortgage, let the lender foreclose, and be better off. More and more people are taking this option. Is it moral?

It may not even be legal. Your mortgage contract says that you "promise to pay" the bank however much you borrowed from it. Many states have laws allowing mortgage lenders to pursue your other assets to get their money back. But that can be difficult and expensive. You may even be able to live in your house payment-free for months while the bank goes through foreclosing on you. Then you can rent another house—possibly one the bank unhappily repossessed from someone else who walked away.

There are other practical problems: your credit rating will be trashed, and you won’t be able to get another mortgage for a few years. Don’t be surprised if your former neighbors don’t take kindly to the effect you have on property values. And there are the hassles of moving under any circumstances: new schools for the kids, and so on. But the main deterrent is honor and shame. If you literally can’t make the payments and still feed your family—that is, if you’re bankrupt—then these things don’t matter. But increasingly, people are walking away from underwater mortgages who could keep paying but choose not to. These cases are called "strategic defaults." Can there really be any justification other than necessity for ratting on a promise and keeping money that you owe to others? (For a firm and eloquent “no,” see our colleague Megan McArdle’s post.)

Perhaps surprisingly, the answer is "yes." There are strong arguments that any feeling of shame or dishonor about walking away from a mortgage is misplaced. Whether these arguments are persuasive is up to you.

First, the bank may not be wholly innocent. Traditionally down payments are supposed to prevent this situation from arising. The larger the down payment, the more a “walker” is walking away from. But in the recent real estate bubble, banks demanded smaller and smaller down payments for larger and larger mortgages to less and less qualified buyers. They encouraged people to take second mortgages every time their house value increased. There was no gun to the head of the home buyer, but there was no gun to the head of the bank, either. It was a folie a deux. Both sides of the deal were foolish. Why shouldn’t both sides suffer when the deal goes bad?

Lenders cannot claim to have been blindsided by defaults. Generally, lenders require borrowers to purchase Private Mortgage Insurance if the loan is greater than 80 percent of the property’s value. This is precisely to off-load some of the risk they are voluntarily taking on.

In the financial world, companies and individuals default on loans all the time, with no stigma. Recently the purchaser of an 11,000-unit housing complex in Manhattan turned the keys over to its creditors and walked away. Tishman-Speyer had paid $5.4 billion for the property late in 2006. It is now worth $1.8 billion. Dan Gross offers several other juicy examples in Slate.

In fact, enabling business people to walk away from debts is vital to capitalism. The corporation was invented to facilitate this very thing. The essence of a corporation is "limited liability." By doing business in corporate form, the shareholders are putting everyone on notice that their liability for the corporation’s debts is limited to the amount they have invested. No matter how much money they may have, and no matter how much the corporation may owe, they can never be asked for more. No one even suggested that "honor" required the shareholders of General Motors, their equity already wiped out, to reach into their own pockets to make good on GM’s obligations.

On the other hand, if many of those 10 million Americans whose mortgages are underwater choose to walk away, it would be a catastrophe for the housing market and probably for the economy. Some people feel that paying your mortgage—even if the house you used it to buy is worth less than what you owe-- is not just honorable but a patriotic duty.