Strategic Default - What You Need to Know Before You Decide to Walk Away

The moving truck pulled away from the curb, loaded with Wallace Farmer’s possessions. He locked the front door for the last time and left town—clutched by a long-simmering anger that finally gave way to relief. Farmer didn’t sell his Baltimore house, worth far less than the $180,000 he paid in 2006. And he didn’t lose it to foreclosure. He walked away from the rowhouse and the mortgage. It’s the bank’s problem now.
“These lenders, they don’t care about the community. They care about their shareholders,” said Farmer. “I’m my only shareholder, and I have to look out for myself.”
Hundreds of thousands of Americans—perhaps as many as one in eight borrowers behind on payments in recent months—have done the same, researchers estimate. Criticized by some as immoral, hailed by others as righteously logical, these “strategic defaulters” have launched a national debate about the right and wrong of personal finance in the wake of the worst housing slump since the Depression.

The homeowners walking away are trying to cut their losses, financial and emotional. But their decision also ripples outward, critics say, undermining neighborhoods, hurting banks and putting the struggling economy at risk.

Farmer, who is emblematic of the boom and bust, has walked away from three Baltimore homes.
While working as a program specialist for the federal government, he noticed the home prices in Baltimore in 2005—rapidly increasing, but much lower than in the District of Columbia—and wanted in. He was so sold on the idea that Baltimore was destined to gentrify that he moved to a rough neighborhood to be an urban pioneer and bought another city home as an investment.

A year later, unsettled by crime, he rented his place out and bought another city property to live in—no money down—with his loan officer’s encouragement.

Then the market turned. One problem after another with his rentals drained his savings, and he couldn’t sell them—a bind many other starry-eyed new investors found themselves in. He tapped his retirement account and borrowed from a relative to pay the mortgages, he said, but could no longer afford the payments and sent the keys to the lenders in 2008. At all costs, he thought, he would hang on to his beautifully rehabbed rowhouse.

Farmer changed his mind by degrees. He was shocked when an appraiser told him last year that the property he’d bought for $180,000—and had appraised for more than $200,000 at the time—had sunk in value to $70,000.

It’s almost certainly worth less now. Nothing sold in his neighborhood for more than $28,000 in the first half of this year. And at least five other rowhouses on his block are vacant.

Farmer, who grew up poor in Detroit, fell into bankruptcy in his 20s and then scrabbled his way into the middle class. Now, he felt the weight of the mortgage debt dragging him back toward square one.
With his $68,500 salary, he could manage the monthly payments. But he brooded. What sort of retirement could he expect now? How much money would his home gobble up in unforeseen maintenance and repairs? Would it ever be worth what he paid for it again?

“I couldn’t sleep at night,” he said. “I thought I was about to have a nervous breakdown.”

He asked his lender for a loan modification and got a trial offer for lower monthly payments this year after a lot of negotiating. He also got scary legal notices and thousands of dollars in late fees because, he says, he was instructed by representatives to stop paying for two months if he wanted to qualify for the modification.

He says that experience made him feel like even more of a sucker. So he started packing. When he looked at his original loan documents and saw he was on the hook for $360,000, interest included, that cemented his decision. “That’s when I said, ‘Yeah, I gotta go,’ ” he recalled. “It’s not even about me being able to afford the mortgage at this point. It’s just not good business sense for me to stay.”

A lender spokesman said the company approves modifications “whenever possible to avoid the damage that occurs to a neighborhood when a borrower walks away or loses a home.”

“The bottom line for us is that we offered him a modification to help him with his payments, and we’re disappointed that he didn’t accept it,” said Tom Kelly, the spokesman.

No one’s taking a census of walkaway borrowers, but estimates suggest a ballooning trend rather than a trickle. About 350,000 mortgage defaults in the first half of last year were “strategic,” up more than 50% from a year earlier, according to a recent analysis by consulting firm Oliver Wyman and credit-reporting agency Experian. A separate study by analysts at financial services firm Morgan Stanley said these defaults rose from “insignificant levels” in mid-2007 to about 12% of all delinquencies in February.

Definitions vary. The Morgan Stanley analysts flagged mortgages that were higher than the home value and whose borrowers were up-to-date on their credit card bills and other non-mortgage obligations. (That’s true of Farmer, who paid off his credit card balances this year).

Few would care about strategic defaults if walkaway borrowers and their lenders were the only parties affected. But homeowners can’t do anything in a vacuum. Foreclosures decrease nearby home values and destabilize an already struggling housing market.

While acknowledging that strategic defaults can be in the best interest of the defaulters, mortgage financier Freddie Mac argues that these ex-homeowners “deplete the personal wealth of their neighbors” and give lenders reason to increase the cost of borrowing for everyone.

“In the end, borrowers considering a strategic default should recognize the damaging impact their actions can have on others,” Donald J. Bisenius, a Freddie Mac executive, wrote on the company’s website.

Luigi Zingales, an entrepreneurship and finance professor at the University of Chicago, thinks walkaway borrowers also underestimate the hit they personally could take. Many states allow lenders to sue borrowers for repayment when a foreclosure sale doesn’t cover the mortgage balance. And there are other consequences.

“Banks will refuse to lend to people who have strategically defaulted, landlords will be leery of renting them apartments, and even potential employers or business partners will steer clear out of concerns about the reliability of those who don’t honor their promises,” he wrote in the urban policy magazine City Journal.

Others say it’s unfair to hold homeowners to a higher standard than corporations, which strategically default on properties without cries of moral turpitude. Brent T. White, a law professor at the University of Arizona, has repeatedly argued that walkaway borrowers are merely opting for one of the two options everyone understands when they take out a mortgage—pay up or relinquish the property.

“The lender already agreed to it, so no one should be surprised,” said Jon Maddux, chief executive of YouWalkAway.com, a California firm that monitors clients’ foreclosure cases and connects them with legal help.

Maddux says some of his clients can afford their mortgage. Others are walking because they have nothing left over after their monthly payments to sock away in savings—or are tapping their savings to make the payments.

“Many of our clients could rent a house for half the payment they have,” he said. And once they switch to renting, “they don’t have to worry about fixing the roof or the toilet if it breaks.”

He takes a dim view of the contention that strategic defaulters are harming their former neighborhoods. “The neighborhood got hurt because the lenders loosened the guidelines and made false values happen in the housing market,” he said.

Strategic defaults are concentrated in areas with widespread negative equity—California, for instance, which does not permit lenders to sue homeowners for mortgage deficiencies.

With prices continuing to drop, some homeowners would need to keep paying for years just to break even.

“When you look at it from a cash-flow perspective, when someone is that far upside down, the decision is easy,” said Sam Khater, a senior economist at CoreLogic. “The issue for most people is their home is more than just a financial vehicle. They have their emotions tied up with it, their friends, their community. It had been their source of wealth. .So I think it’s hard for homeowners to walk away.”

Farmer, the Baltimore resident, said it was not a decision he made quickly. He was so set on staying that he fixed roof damage caused by February’s back-to-back snowstorms and repainted the interior this spring. Over his four years there, he poured $20,000 into improvements and repairs. It was the only place he ever decorated for Christmas. It was the only place that felt like home. “I love this house. I do,” he said, sitting in the kitchen shortly before he left. “Even with the neighborhood as rough as it is, I love this house.”

The move changed his life. He went from five bedrooms in Baltimore—so much space he didn’t fill it all up—to one bedroom in Forestville, Md. Before he left, he cast off possessions, giving furniture to friends, donating clothes to charity, selling dishes and taking his cat to an animal shelter because his new apartment doesn’t allow pets.

Some things he was glad to leave behind: The long commute, the neighborhood crime, the heavy-duty window bars and metal security screens around the back door that made him feel caged in. The $1,350 mortgage payment and heating bills that sometimes topped $500 a month.

Despite the warnings about landlords leery of renters with poor credit, Farmer said he had no problem finding an apartment complex that would take him. His monthly rent: $1,000, with utilities and gym membership included. “I’ll be saving a lot of money,” he said.

That’s his first priority. He came to Baltimore to build a bigger nest egg and help send his four siblings’ kids to college so they would get a better start than he did. He left five years later with credit ruined and savings depleted. Because he anticipates that Chase might try to garnish his wages, he planned to file for bankruptcy protection.

With real estate off the table as an investment strategy, his new financial plan is spending less and working more. “I’ve already lined up a part-time job where I’ll be working on the weekend,” he said.
Now, more than a month removed from the house he left behind, Farmer says he feels like he has a chance to start again. “I am so at peace,” he said.

The morning that movers put what remained of his life into a small truck, he was anything but. “I should have walked a long time ago,” he said in frustration to Duane Saunders, a friend who lives in West Baltimore. “Live and learn,” Saunders replied.

(c) 2010, The Baltimore Sun.
Distributed by McClatchy-Tribune Information Services.