Two Steps Backwards in the Mortgage Industry

Roger Lowenstein, in the New York Times, suggests that homeowners should walk away from their mortgages. His theory, in effect is that homeowners must walk away from their mortgages in order to straighten up the banks into not lending more than the homes are worth.

I agree with the premise. The system is broken. Banks make loans on too high of a valuation for home prices. They do not pay enough attention to the credit-worthiness of the borrower, nor do banks and traders in the secondary market who purchase those mortgages.

So, there is not enough risk on the banks hands to balance out their risk taking.

At the same time, the flip side of this situation has its own problems.

Homeowners have a lot of incentive to speculate. Larger mortgages means less money to put down up front. If the price goes up, they sell and capture the profits. If the price goes down, what is the risk?

The risk of foreclosure should be that their credit rating gets punished and that their home and potentially other assets are seized to pay off the mortgage. However, these risks are just not realistic currently.

In only a few states are banks able to go after the borrowers assets (other than the house), and lenders rarely do so. Plus, the potential harm to personal credit ratings does not seem that bad at all. Maybe it lasts on your record for 5-7 years? And if everyone else is doing it, considering the situation, will future creditors look at it that poorly anyway?

So, we are still in a situation where banks are encouraged to lend loosely and homeowners are encouraged to borrow aggressively and walk away. It should be the exact opposite. Banks should be careful with their money (our money, effectively). Homeowners should be scared to borrow more than they can afford to pay back.

So, is encouraging homeowners to walk away from their homes a good idea? In principle it sounds accurate. It should and would force banks to revise their practices.

However, in the long term, I think it is a very dangerous precident to set. Lowenstein himself admits defaults should not be the rule in a perfectly functioning society. So, is it smart to go backwards in order to move forwards? In regards to this industry, I think not.

It is not like this industry will clean itself out in a year and then we can go back to normal. The government beauracracy and mortgage industry pace will drag this on for years, if not decades. I fear that stepping back and encouraging defaults may result in momentum in the wrong direction. This is a huge train to turn around once it gets moving. We’re dealing with a very large turning radius here.

While Lowenstein’s ideas are keen, the downside is incomprehensible. I think it is better to clean up the mess from within – help banks act responsibly through lending limits and incentivized risk management – while letting the homeowners work through the pain on their own and maintaining some semblance of honor toward their contracts. Keeping some honor in contracts is a must in a capitalistic society such as ours.

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