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Are "Strategic" Defaulters on Home Mortgages Like Barbarians at the Gates of Rome?

Are "Strategic" Defaulters on Home Mortgages Like Barbarians at the Gates of Rome?

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Published by Ken Gibert
There has been a lot of discussion over whether people who are defaulting on their mortgages but remaining in their homes are "bad" for the economy. This article gives some economic and legal background on the question. The real problem was a change in investment regulations allowing banks to hide their real value. They would have to "fess up" in order to foreclose on the home owners. This would put many of them in bankruptcy. And so the party goes on.
There has been a lot of discussion over whether people who are defaulting on their mortgages but remaining in their homes are "bad" for the economy. This article gives some economic and legal background on the question. The real problem was a change in investment regulations allowing banks to hide their real value. They would have to "fess up" in order to foreclose on the home owners. This would put many of them in bankruptcy. And so the party goes on.

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Published by: Ken Gibert on Jun 05, 2010
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06/06/2010

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Are “Strategic” Defaulters on Home Mortgages Barbarians atthe Walls of Rome?
Are people who are “strategically” defaulting on their home mortgages akin to barbarianslooting Rome? Does the fact that more people are defaulting result in a weakening of the rule of law inour society? Justice Litle writes convincingly that the rise of strategic defaults means our country is onthe road to ruin,Strategic Defaulters on Home Mortgages Are Barbarians Looting Rome, but I wouldargue that it is not the strategic defaulters who are greasing our descent into hell. They're just minor bit players in an overall drama.Here is an excerpt from Litle's article, evocatively and beautifully written as always. I will let itspeak for itself.
You cannot have a functional economic system in which a critical mass of  participants decide "not paying their debts" is okay. When the system isallowed to rot, the system eventually breaks down.
Believe it or not, it comes back to culture. In a culture where paying one'sdebts and honoring one's commitments is seen as a clear moral obligation,the rule of law is intact. When the state of the union is good, these culturalnorms are subtly reinforced in a thousand different ways. A sense of fairness – though frayed at the edges at times – generally prevails.When you
lose
that sense of cultural obligation though – when people startsaying "Forget the home mortgage, let's go have a steak and visit the casino" – the social fabric is torn asunder.I first wrote about people defaulting on their mortgages in 2007. See, e.g.,They Might Not BeAble to Foreclose on Your House. I pointed out there that people who are facing eviction might get areprieve because of the complexity of the mortgage backed securities which sometimes rendersforeclosure impossible. Because the collateral damage of foreclosure can be so harsh, and because itwas early in the wave of home loan defaults, I took a very cautious view of the advisability of defaultand possible salvation. Since that time, though, a much more important trend has developed. People areincreasingly choosing to default on their mortgages as a “strategic” measure. I have pointed out theconnection of the mortgage backed securities and the banking bailouts.Why the Alphabet DerivativesHave Brought So Much Destruction.In short, the change to the accounting regulations governing how banks and other financialinstitutions report the value of their speculative holdings has done the real damage to our economy, andstrategic defaults are merely an inevitable consequence of that change. Specifically, before March of 2009, banks were required to mark their investments “to market.” Marking to market means that acompany holding assets must periodically reassign values to its assets for book-keeping purposes. Anexample of that would be a stock market account. Every night—and actually at all times during the day —you can look at your stock market account and get an up to the minute idea of the value of the stocksyou hold. That is easy for stocks, which are priced by the market on a continual basis, but much harder for more complicated assets. Marking to the market means that the company must attempt to determine
 
the current market value of its assets at certain intervals. And in the case of the banks, the values of these assets can determine whether the bank is insolvent or running afoul of reserve requirements.When mortgage backed securities (mbses) became “troubled” (government-speak for peoplediscovering they were worthless), the banks and investment firms were being forced to show largelosses of capital, losses which in fact revealed that they were either insolvent or short of reserves.Rather than allow the market to sort things out and deep-six some of the largest banks in existence,several bail-outs were instituted.The most important of the bail-outs was perhaps least publicized: the dropping of the mark tomarket requirement. Under the new FASB regulations, banks are permitted to assign “historical” valuesto their investments. If they paid a dollar for mbses, they could carry the mbses as assets worth a dollar even though they had become worthless. This equally applies to home mortgages themselves. Many people call this “mark to make-believe.” Notice that the banks balance sheets then lost any relationshipto reality, and any investor relying on the supposed strength of the underlying business was defrauded.With a stroke of that pen, the banks became “solvent” again, the banking crisis was over, andthe 2009 “bull market” began. Well. It sounded good, anyway. But the changes actually were an earlyabandonment of the “transparency” Obama claimed to want to restore to government and a wholesaleadoption of fraudulent accounting within the very heart of our economy. The “bull market” thatfollowed, and all the claims of “economic recovery,” have rested on the deception permitted by thatregulatory change. And the rosy condition of the largest banks is a deception. Despite the regulatorychanges, banks have been shut down at historic rates this year, and many of them are holding mbseswhich they have valued for their book-keeping purposes as
100% or more in excess of their actual value
. The FDIC is expected to run 20 billion dollars in deficit this year- a tab the federal governmentwill pick up.Just a drop in the ocean of ongoing, massive subsidies to the banks to hide their true condition.Of critical importance to the strategic home mortgage defaulters, however, is the fact that the banks are maintaining mortgages at their “historic” rather than (much smaller) actual value.
Foreclosing is a historical event that would force a revaluation of the assets
under the regulations,and thus the banks
cannot 
foreclose on mortgages without revealing their actual financial condition.Since their actual condition is insolvency, their hands are tied, and they are not, in fact, foreclosing.Some have called the resulting bank policy “extend and pretend,” referring to the banks extending theloans and pretending they were not in default. People have accordingly been free to stop paying their mortgages but still remain in their houses, and naturally more of them are doing so as they see othersdoing it. For an interesting discussion of the trend, watch the video atTech Ticker .The stigma attached to such opportunism is gradually disappearing.As many have pointed out, mortgages are hard-nosed, arms-length transactions, and the bankswrote the contracts and more or less imposed the terms on the borrowers. Additionally, American lawactually favors the breaching of contracts, which is normally a beneficial action in a free marketeconomy.How so, you ask?When two parties enter a contract, each one receives certain benefits in exchange for promiseswhich will cost something to provide. Upon breaching a contract, the breaching party is still
 
responsible for providing the promised benefits. For example, if I agree to provide you 100 widgets for $10 apiece, and my profit per widget is $1, if you break the contract you will owe me $100 in damages plus costs related to production which cannot be “mitigated” (reduced or eliminated) by normal business practices. Thus I get my contracted-for profit, and you are free to find cheaper widgetselsewhere-or else to do without widgets at all. This permits suppliers to lock in their profits and makenecessary production arrangements and buyers to find the ultimately cheapest goods or best ways touse their resources. That is beneficial to everybody and fosters competition and improvement.Of course there are transaction costs in that equation. Litigation costs, for example, andcollateral “trust” issues might arise. But these are generally regarded as of less importance than the freeeconomic movement that allowing contracts to be broken provides. And that is why “damages” for  breach of contract do not include “punitive” damages which might impede or prevent contracts from being freely entered or breached. In mortgages, for example, the consequence for breaching thecontract is normally foreclosure and often damage to credit, traditionally more than enough to make people keep paying. Humiliation or stigma is just an “extra” which average people, but certainly notsophisticated businesses or business people, sometimes feel and which banks do their best toencourage.In other words, the law is not breaking down when people breach their contracts. The law isfunctioning as intended and remains “intact.”Justice Litle is certainly not naïve, and he is probably right in his contention that an economicsystem breaks down as people begin feeling free to disregard their financial obligations. My point issimply that the greater breakdown has already occurred. That happened when FASB regulations werechanged to allow the banks to commit systemic fraud. Or perhaps, as I have argued elsewhere, thegreater breakdown occurred with the continual adoption of governmental deficit spending, which is aform of buying things without having to pay a political price for benefits bestowed. This fosters anational “free lunch” mentality and also directly weakens democracy by allowing politicians to make promises without accountability.To claim that mortgage defaulters, acting in the face of these much larger economic forces arecausing any real problem is akin to claiming that the tail wags the dog. Or that a flea does.Litle pointed out another interesting phenomenon that is also an unintended consequence of thatFASB change. That is, as people have been abandoning their mortgage payments but remaining in their houses, their 
disposable income has increased 
. That is because their housing, previously one of their largest expenses, has become “free,” and they can use their money on steaks and casinos (or healthinsurance or gas, more likely). It is hardly a coincidence that consumer spending has increased in theface of this trend, therefore, and in our “consumer economy” that has translated into heartening reportsof increased GDP and other signs of economic “recovery.” The whole process is allowed and lubricated by oceans of deficit spending subsidizing the banks and propping them up. Since taking action to haltthe abandonment of mortgages would reduce available money and hurt the “recovery,” government haslittle incentive to put a stop to what is happening.In my opinion, changing the FASB regulations killed the American economy. Like a chickenrunning around after its head has been cut off, though, we just don't know it yet.At the very heart of the U.S. expansion over the past 60 years has been economic transparency.People have invested money in our country over that time because the markets were relatively safe

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