A "moral obligation"?

This morning on NPR I heard a man talk about his mortgage refinancing dilemma. He owes approximately $300,000 on a house now worth less than half that much. He is seriously “underwater.” Through the federal mortgage modification program, the bank holding his mortgage offered him a significantly reduced interest rate and much lower payments. There was just one catch with the new terms: a balloon payment of over $100,000 to pay off the loan.

The man figured he would accept the offer even though he knew it was a bad one. He doubted if he would ever break even on the house (he’s probably right). A lot of his neighbors in similar situations had walked away from their houses and mortgages but he was reluctant to do that. His mortgage was a contract and it just didn’t seem right to break it.

This news segment also interviewed a bank spokesman who endorsed this man’s attitude. Customers have a “moral obligation” to honor their mortgages. They’ve made promises to their banks and should abide by their commitments.

What’s good for the goose apparently isn’t necessarily good for the gander, however. As reported on Huffington Post and elsewhere, over the weekend an investment group turned over its keys to one of the largest residential properties in the country: the 56-building, 11,232-unit Peter Cooper Village and Stuyvesant Town apartment complex in Manhattan. Tishman Speyer Properties and a group of other investors bought the property just before the housing bubble burst for $5.4 billion—the single biggest residential property purchase in U.S. history. Today it’s valued at $1.8 billion. The loan default: $4.4 billion. Among the biggest losers is California’s public employees’ pension fund which invested a half-billion dollars, now all gone.

Last month, Morgan Stanley walked away from buildings it had purchased in San Francisco for almost $2.5 billion. Now worth much less, the bank decided to cut its losses and give up the property in what it called “a negotiated transfer to our lenders." It’s not clear anything was actually negotiated besides what drop box the keys should be left in.

There has been no outburst of moralizing outrage on Wall Street at these and other multi-biillion dollar corporate walk-aways. The prospect of individual home mortgage holders following this example has many banks and mortgage companies scared to death, however. It’s estimated that a quarter of all home mortgage holders are underwater, i.e. they owe more on their houses than they are worth. A million mortgaged properties were returned to banks last year; double the number in 2008, which was double the number in 2007.

The prospect of millions of houses suddenly being given back to the banks has caused many to play the morality card. Former Treasury Secretary Hank Paulson denounced anyone who does this as “not honoring his obligations.” A mortgage association president asked rhetorically what message such behavior sends to one’s family, kids and friends.

Many financial advisors and economists say the message probably is, “Mom/dad, you’re pretty smart.” They’re smart in at least recognizing their first mistake in purchasing the property and deciding not to throw good money after bad. Of course, every situation is different and anyone contemplating such action should consult both a disinterested financial advisor and an attorney. A mortgage default will adversely affect one’s credit rating. It may well, however, be the start of a personal and family financial recovery—something holding an underwater mortgage could well prevent ever happening.

But is such behavior immoral? What the corporate mega-defaulters know, and what everyone else needs to remember, is that one’s moral obligation is to abide by the terms of the contract—including its provisions for breaking the contract. It's common knowledge that when you borrow money to purchase property and then stop paying on the loan, the property can be claimed by the loan holder. That’s in the contract which both sides agreed to. The defaulter isn’t jailed, put in stocks, or made to wear a funny hat. He or she just loses the use of the property and any accumulated equity—which is non-existent for millions of people today. It’s the risk the bank accepted in giving you the loan. It’s one of the reasons you’re paying interest on that loan. (The New York Times also has a good piece on this topic.)

As I’ve written before, the bank bailout has involved a lot of smoke and mirrors. Many banks are claiming on their balance sheets the full pre-recession value of mortgaged properties in their portfolios. This charade will be painfully exposed if the owners of these properties default. It could yet cause some of the “too big to fail banks” to fail.

Banks knowingly shoveled hundreds of billions of dollars into the over-heated housing market, making enormous profits at each step of the process. That’s what blew-up the bubble. Now that the bubble’s burst, banks are scrambling to avoid the consequences of the risks they took, hoping to pass them off to their underwater mortgage holders. Homeowners have every right to pass them right back. Banks are only adding to the distress of such people by manipulating them with guilt and claiming their behavior is immoral. If there is any immoral behavior here it's with the banks, not distressed mortgage holders.