Foreclosure Options

The discussion in the comments of banks who have (presumably accidentally) foreclosed on current borrowers reminds me of a conversation I had a few months ago with a friend.  "Why shouldn't I just walk away if I'm underwater?" he asked.  "They signed a contract: either they get the payment, or they get the house."

For starters, as I noted, this isn't actually true; mortgages are not structured like one-sided option contracts.  They're promissary notes, not call options.  And most states (including Maryland, where he lives) are recourse states, meaning that you owe the full amount of the mortgage regardless of foreclosure; if the bank sells the house for less than you owe, they can come after you for the difference.  (This is somewhat complicated by "one action states" where the bank has to choose between foreclosing, and suing; but that doesn't really change the point.)  People have gotten the misimpression that you can "choose between giving the bank the house, or paying the mortgage" because two of the hardest hit states, California and Arizona, are non-recourse, and those states have generated a lot of news items about "jingle mail".  But the majority of homeowners signed a contract to pay the full value of their mortgage, not some exotic option contract.  If they try to exercise their "option" they may find themselves in a lot of trouble as the bank comes after them for the balance, and forces them into bankruptcy.

But another question occurred to me.  "Let's turn it around," I asked.  "What if the bank decided that it wanted to exercise the same sort of option?"

"What do you mean?"

"What if the bank foreclosed on your house, even though you made the payments, because it figured it could make more money taking the house and selling it?"  (Not a likely scenario, I know, but a useful thought experiment.)

I could tell from his face that he didn't think this would be fair.  But assuming that the bank can get away with it, why would it be wrong for them to do this? (We were discussing morality, not practicality) If you get to decide when they get the house, and when they get the payments, why is it unfair when they exercise the same option?

This is not to argue that people shouldn't ever walk away from the house--as a rule of thumb, if you've reasonably trimmed your expenses and you're still dipping into savings to pay the mortgage, and you have no reason to believe that your income will improve, I think you should walk away.  But if you really think that there's no moral content to sticking the bank with the house, when you are perfectly able to perform your contract, then it seems to me you should not be outraged when a bank forecloses on people who have been making their payments.  After all, they're just exercising their option to foreclose.

Me, I think that there is a moral obligation to try your best to live up to the promises you made when you signed that promissory note, and a moral obligation for banks to perform their end of the contract (like, not foreclosing on someone who has made their payments--and making lavish restitution to anyone who finds their home accidentally sold out from under them).  But I don't see why the moral obligations are only binding on one side.

Update: Already I have a number of readers who seem to think that there is some sort of option specified in the mortgage contract.  There isn't. If you had an exit clause where you could walk away from your mortgage while turning over the house, then I agree that there would be nothing wrong with executing it.  But the ordinary mortgage note does not contain such a clause; it just provides security for the lender in the event that you do default. So saying "that's not how the contract is structured" is beside the point; the contract isn't structured as an option for either side.  Your mortgage does not give you the "right" to default, while denying the right of foreclosure to the lender except under certain circumstances.   But contracts do not try to compel performance, even when we recognize that the performer has a moral obligation, because this is impossible--you can sock an adulterer with an ugly settlement in a divorce case, but you can't make him go back to his wife and be faithful.  So we specify penalties for breach instead.  That doesn't mean that breach is morally neutral.

The advocates of jingle mail are essentially arguing that there's an embedded option, and nothing wrong with exercising it; not that there is an actual option.  My point is that if lenders utilized such an embedded option to take the house when it was to their profit, we'd think it was monstrous, and the outcry would be loud and long to curtail whatever legal dodge they'd found to let them get away with it.  Rightfully so.

I don't think that we should seek legal remedies against those who walk away from underwater mortgages.  But I still think it's wrong if you have the means to pay, just as it would be wrong for banks to seize the house you'd been faithfully making payments on, even if they could get a judge to sign off.