Why I think strategic default is ok

A not so recent NPR story and a few podcasts and articles I’ve listened to and read have got me thinking about the following question: “If you find yourself underwater on your house (i.e. you owe more than your house is worth) is it morally ok to default on the loan and walk away from the house even if you are still able to make the monthly mortgage payments?”

When I first heard the question I immediately thought no. I figured that if you signed your name promising to pay you should feel morally obligated to do so as long as you were able to. Plus, with homeownership such a systemically important sector of our economy, a mass default would probably cause serious chaos. I have since decided that it is not immoral to strategically default on your mortgage if you find it is in your best interest to do so.

When you buy a house and take out a mortgage, you not only agree to amortize the loan over a long period of time, but there are several other provisions within the contract that you and the bank agree on, I would like to talk about one of these provisions—the embedded option to default. (Stay tuned for another blog entitled “why the government should get out of the mortgage market” that will discuss another embedded option—the pre-payment option)

Most states require bank to offer home loans with no other collateral than the home itself (called a non-recourse loan). If you cease to pay on the loan, the bank cannot come after your other assets—your 401k, your car, your jewelry and they can’t garner your wages until you’ve paid them back, they can simply take your house. This clause implies that the home buyer has an option to sell the house back to the bank for the amount he/she owes on it, even if the market rate of the house is lower than the amount of the loan. In finance this would be analogous to what is known as a put option. For example, suppose I buy a stock for $50 from Steve. I want to guarantee that in a year I will have be able to sell the stock for at least $50 so I pay Joe $1 for the right (not the obligation) to sell my stock to him for $50 no matter what it’s worth in 1 year. If In a year the stock price is $60, I will not sell my stock to Joe for $50 because I can sell it for $60 on the market. If, however, after a year, the price of the stock is $40, I can choose to sell it to Joe for $50. I lose only the $1 I paid to Joe (and I guess the opportunity cost of making the riskless rate of interest on the $50, but alas I digress). In a similar way when you buy a house you are also buying the option to sell the house back to the bank for what you owe on it, even though the bank will not be able to sell it for that much on the market. The important point I want to make is that THIS OPTION IS NOT FREE. Just like in the stock example I had to pay Joe $1 (the option premium) for the option, home buyers pay banks for this implied option through higher rates of interest (this option was probably underpriced in the market, but it existed nonetheless).

To say that homeowners should feel obligated to continue to pay on their houses even though they owe more than the house is worth is like saying to the stock buyer when the stock price is $40 on the option expiration date that he can’t sell his stock to Joe for $50 anymore, that that is immoral. Joe took your $1, he agreed to buy the stock for $50 no matter what it was worth. The bank took your interest and agreed that you could turn in the keys and they wouldn't take your Picasso if the house didn’t cover the loan (we’ll ignore the cost of a ruined credit score for this thought exercise).

To me the real question isn’t whether or not strategic default is immoral; it’s whether the government should require this provision to be in mortgage contracts. My inclination is that it should not (maybe that’s the libertarian in my blood). In Canada this embedded option is not required and as far as I know their mortgage market works fine. I imagine a world where banks offer several different types of mortgages with several different rates of interest. For those who want to protect themselves from large swings in house prices, there would be a mortgage with a non-recourse provision which charges a higher rate of interest. For those who want a lower rate of interest and are comfortable assuming the risk their house will decline in value, there would be recourse possible loans. I imagine that the option doesn’t even need to be embedded in the mortgage in the first place! Perhaps the bank offers a simple recourse loan and you can buy the option to sell your house for what you owe on it from an insurance company (options are insurance products).

What do you think? Is it immoral to default on your house if you can afford the payments? Should states require that mortgages have a non-recourse provision? I think there are rational arguments on both sides of these two questions.

-Andrew Berger

Side note: I said that I think the option was probably mispriced in the housing market—I think that’s true. This probably stems from the increased volatility in housing prices in general. Traditionally housing has been viewed as a stable investment, one that grows slowly (perhaps just a bit faster than inflation) and consistently, so this option was pretty worthless. In the mid 2000s we saw a boom in housing prices followed by a sharp decline. Maybe banks started charging less for this option when they thought housing prices would never fall, but really they should have seen how volatility had increased in housing prices and charged more for these options. Generally speaking increased volatility increases the value of options.