Mortgage Debt and the "Decency Tax"

A couple of days ago I wrote about “the bankruptcy planning problem”—how you can take advantage of bankruptcy, but you can’t plan for it (link). Here’s a new wrinkle on the same theme that is just too cool to ignore.

Here’s the deal: you bought your nice California home for (say) a million. You’ve paid a couple of years on the mortgage but you barely scratched the surface of the balance due. You decide you made a mistake. You walk away. The lender sells the house for $800,000. Question, can he come after you for the shortfall?

The short answer is “no.” California operates under an “anti-deficiency” rule, which says that the lender can look to the house to pay his debt, but not the owner (for a longer answer, see infra). The practical effect is that the California home purchase contains an “implied put option” that allows the buyer to dump the property back on the seller (or the lender) when the value goes down.

This has been the rule since—I don’t know when, but it was well established when I came to California in 1969. I assume it goes back to the Depression.

And that’s the key: since the bottom of the Depression the value of California real estate has gone (not quite) straight up, and the lack of a deficiency claim has just never been a big deal.

Until now. Apparently now, for the first time ever, debtors in battalions are walking away from their real estate debt. And grownups who ought to know better are getting huffy about it.

A good place to start is with the (normally quite sane and sensible) Calculated Risk (link). In a long and unusually convoluted post, he* undertakes to show that real estate loans “are not, actually, options contracts.” But then he goes on to show how the industry prices them exactly that way (he isn’t addressing himself specifically to California but I don’t think his analysis would be materially different if he were). And then he discusses what he calls “the ruthless borrower:” he says:

“Ruthless” isn’t really intended to be a casual insult; it is in fact the term we use to describe borrowers who can pay their debts but choose not to, because there is a greater financial return to that borrower in defaulting as opposed to not defaulting.

…or, he might have said, somebody who chooses to operate within the limits of the contract instead of paying the lender more than he is due. Then in a dynamite aside, he adds:

(There are always people who have no trouble with ruthlessness; they often get the CEO job. Most of us have at least moderately strong inhibitions about ruthless behavior.)

Bingo. I take this as a concession that the industry survives on the predicate that the borrowers are more honest and honorable than the lenders.

In a somewhat more muted town, here’s Housingwire, for example (link), and Market Movers (link) rolling their eyes over a new “business” that must be regarded as the logical conclusion of this sequence—a firm that (for money) will tell you just how to do it. I concede, it is hard for me to see just what kind of “advice” these “consultants” can offer that would justify the fees they take—but I suspect that is not what is causing the eye-rolling in polite company.

I admit that I did not grow up in a world where people walked freely away from their debts. What really frosts me, I guess, is that these lenders had a whole lifetime to plan for this—and (more important) I’m sure to a moral certainty that they’ve priced it into their models. No, more precisely: what they’ve priced is the expectation that customers would not, in the end, exercise their legal rights here; that they would not, in the end, act like CEOs. Call it a “decency tax”—perhaps one of the most regressive our economy has on offer.

Tedious Footnote on California Mortgage Law: There are really two rules involved here. One rule bars deficiency judgments for the money you borrowed to buy your home. The other concerns the procedure the creditor uses to liquidate his claim. The creditor has two choices: he can go through a full-scale judicial foreclosure, or he can opt for a stripped-down private sale. If he opts for private sale, he can’t go after a deficiency. Through most of my active life here, creditors rarely went the foreclosure route: it was almost always too expensive, and the payoff was too small. If the market continues off the cliff, we might well see more judicial foreclosures with deficiency claims. And note that the “homeowner protection” rule doesn’t apply to refis. So a debtor with a funny-money loan, faced with a creditor willing to sweat out a foreclosure, might well find himself faced with a deficiency judgment after all.

And let’s not even think about taxes…

[Protective Boilerplate: This is not legal advice. It is blogchat, which is different.]

Update, January 2008: "She." The author was Tanta, of whose identity I was not then aware. Tanta was, of course, a superb analyst/commentator, whose absence leaves a gaping hole. But I still think I was right on this one.