How Easy Should Walking Away From a Mortgage Be?

A new California law would make strategic defaults easier, but that could harm its housing market's recovery.

One of the reasons why foreclosures have been so prevalent is because in some states they are relatively painless. States with non-recourse mortgages simply allow homeowners to walk away from their homes, no questions asked. That has resulted in lots of underwater homeowners realizing that it doesn't pay to keep paying their house, so they simply stop and find somewhere cheaper to live. California has a non-recourse policy for new mortgages, but not for refinanced loans. A new law would reconcile this disparity.

Currently, the state has a sort of odd two-tiered system. When you buy a home, the original loan is non-recourse, so you can just walk away. But if you refinance the home, then the bank can chase after your assets to collect the full balance if you default. Lawmakers want to reconcile these two scenarios, so they sought to make these refinanced loans non-recourse too.

For the obvious reason of wanting a claim on this debt, banks objected. As a result, the law was revised before it passed. The New York Times reports:

The bill that passed the Senate by a lopsided vote of 30 to 4 would protect former homeowners up to the amount of their original loan. For instance, a family that took out a $500,000 mortgage to buy a house and then refinanced and took cash out, swelling their loan to $600,000, would be released from claims on the original sum but remain vulnerable on the $100,000.

This is a strange sort of hybrid. It would provide banks with a little protection, but also still provide some cover for homeowners to walk away if their loans are way underwater. It's a compromise.

On one hand, it's a welcome change. Banks arguably have too much incentive to persuade borrowers with great offers for cash-out refinancing. This sucks equity out of the housing market. Under current law, not only do banks get additional loan volume out of the deal, but suddenly the original mortgage also becomes full-recourse. This may have been part of the motivation on the part of banks to offer current homeowners wacky new mortgage products that included a cash bonus. Through the new law, however, any additional loan would stand on its own.

On the other hand, non-recourse loans are a problem for the housing market, as strategic defaults continue to occur in large numbers. While it's a nice idea to provide homeowners the opportunity to simply walk away from a home if they don't feel like paying their obligation anymore, it makes the housing market's problems worse. Every time a borrower chooses to strategically default, home inventory increases. That puts pressure on home prices. Values then decline further, and more homeowners find themselves underwater. Consequently, those homeowners then begin considering strategic default. You can see the downward spiral that occurs.

These full-recourse refinanced mortgages were actually helping to prevent some homeowners from foreclosing by choice. If given the opportunity to walk with a much smaller debt due, they may decide to do so. That could worsen California's housing market. According to the bill, however, it won't be effective until June 1, 2011, so Californians can hope that its housing market has exhausted most of its foreclosures by then.

Ultimately, this law would correct a sort of loophole for banks to refinance their way out of non-recourse loans. But it also raises the question of whether that loophole might be helping to prevent the state's housing market from deteriorating even further. While it's undesirable to force homeowners to stay in underwater homes, it might be worse if the state finds itself sliding down a steeper slope to lower home prices.