In phase one of the foreclosure crisis, policy-makers and news media have focused mainly on homeowners who lose their homes because they can't afford to make mortgage payments.
The next big issue is "strategic default" -- homeowners who can afford their payments but walk away from mortgages and accept foreclosure because they're facing financial stress, and/or their homes are worth less than the loan amounts.
There's an especially large concentration of these underwater mortgages among older Americans. Many pre-retirement baby boomers took on higher mortgage debt in the years running up to the real estate crash; a study this year by the Center for Economic and Policy Research found that 30% of Americans age 45 to 54 are underwater.
That means they'd need to bring cash to a closing in the case of a sale -- say, when it comes time to make a retirement- or health-related move. And mortgages are a key component in retirement planning, since debt reduction is one of the best ways to improve retirement security.
University of Arizona law professor Brent T. White generated a flurry of attention last month when he suggested in a research paper that the rational economic move for some underwater homeowners would be to default on their loans and give their homes back to the bank.
Since then, news media coverage of strategic default has been growing. The Wall Street Journal last month profiled California homeowners who opted to default in order to get out from high mortgage payments, instead renting similar properties in their neighborhoods for a fraction of the monthly cost.
This past weekend, the New York Times wrote that the Obama Administration's Making Home Affordable loan modification program may only be postponing the inevitable day of reckoning for millions of homeowners who will never be able to afford their mortgages and ultimately will face foreclosure.
Economist Mark Zandi argues in a Times piece that underwater loans are a much more important piece of the puzzle than forced foreclosures:
Mr. Zandi argues that the administration needs a new initiative that attacks a primary source of foreclosures: the roughly 15 million American homeowners who are underwater, meaning they owe the bank more than their home is worth.
Increasingly, such borrowers are inclined to walk away and accept foreclosure, rather than continuing to make payments on properties in which they own no equity. A paper by researchers at the Amherst Securities Group suggests that being underwater "is a far more important predictor of defaults than unemployment."
Strategic default poses serious moral and legal issues. Some experts argue that consumers should look at their homes as housing, not an investment and honor the contractual promises made when they took out their loans.
And, despite media coverage of the increasing number of strategic defaults, the percentage of those who do walk away from mortgages is relatively low. White's analysis shows that only 25 percent of mortgage defaults are strategic; the percentage isn't higher, he argues, due to homeowners' perceived shame and guilt of foreclosure, and fear of the consequences.
White further argues that that the emotional constraints are actively cultivated by the government and "social control agents" to encourage homeowners to follow social and moral norms related to the honoring of financial obligations. At same time, homeowners are encouraged to ignore market and legal norms under which strategic default might be viable and the smartest financial decision.
White's definition of "social control agents" include the media and an array of financial counseling services. Although the latter often are non-profit organizations presenting themselves as community-based organizations, many receive funds from government and financial services companies, which have a vested interest in discouraging defaults.
Counseling services that receive HUD certification cannot advise their clients to default. White told me in a recent interview of his conversation with a counselor at one industry-funded agency that counseled 3,000 people in 2008 on how to avoid foreclosure. That agency did an assessment at the end of the year of whether any of these would have been better off with strategic default; the assessment concluded that 53 percent would have been better off due to an unsustainable debt-to-incomer ratio. But, the agency couldn't tell clients that, due to its industry funding.
Credit scores loom large in all of this. White argues that homeowners fear falling scores, yet, most people can recover a good score within two to three years if they stay current on other payments. Walking away from a mortgage frees up cash to do that, he says, and the sky will not fall in during the interim.
White also argues that our current system is set up to remedy the housing crash on the backs of consumers, who are encouraged to keep making payments on real estate where they will never see a return; in the meantime, banks get billions in bailout funds, and are allowed to drag their feet on loan modifications.
All that aside, White took pains during our interview to make clear that he isn't advising homeowners to default. "This is an academic piece that makes the observation that it would be in the best [economic] interest of many consumers to walk away, but that they don' do so due to a double standard -- one for Main Street, the other for lenders and banks. This results in distributional inequality, and propping up market on the backs of the middle class."
White also notes that the wisdom of a strategic default depends heavily on state laws. Some states have non-recourse laws that prevent banks from going after the personal assets of homeowners who default; others don't offer consumers this protection (Click here for more information on non-recourse states).
Other important variables, White says, include how far underwater the loan has become and the prospects for a real estate recovery in a given market. "People need to consult with an attorney and and a financial adviser before making any decision. But I don't believe guilt and shame are good reasons to stay in a house."