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A provocative paper by Brent White, a law professor at the University of Arizona, makes the case that borrowers are actually suffering from a “norm asymmetry.” In other words, they think they are obligated to repay their loans even if it is not in their financial interest to do so, while their lenders are free to do whatever maximizes profits. It’s as if borrowers are playing in a poker game in which they are the only ones who think bluffing is unethical.

borrowers in nonrecourse states pay extra for the right to default without recourse. In a report prepared for the Department of Housing and Urban Development, Susan Woodward, an economist, estimated that home buyers in such states paid an extra $800 in closing costs for each $100,000 they borrowed. These fees are not made explicit to the borrower, but if they were, more people might be willing to default, figuring that they had paid for the right to do so.

Editor’s Note: Here is a strategy straight out of the tax shelter playbook that could result in widespread relief for homeowners underwater. It comes from a high-finance tax shelter expert who shall remain unnamed. He and a group of other people with real money are thinking of establishing a clearinghouse for these transactions.The author of this strategy ranks very high in finance and law but he cautions, as do I, that you should utilize the services of only the most sophisticated property lawyers licensed to do business in appropriate jurisdictions before initiating any action under this delightful reversal of fortune, restoring equity, possession and clearing title to the millions of properties that could fall under the rubric of his plan. He even invites others to compete with his group, starting their own clearing houses (like a dating service) since he obviously could not handle all the volume.

The bottom line is that it leaves you in your home paying low rent on a long-term lease, forces the pretender lender (non-creditor) to file a judicial foreclosure, and throws a monkey wrench into the current  foreclosure scheme. I am not endorsing it, just reporting it. This is not legal advice. It is for information and entertainment purposes.

1. John Smith and Mary Jones each own homes that are underwater. Maybe they live near each other, maybe they don’t. To make it simple let’s assume they are in the same subdivision in the same model house and each owes $500,000 on a house that is now worth $250,000. Their payments for amortization and interest are currently $3500 per month. The likelihood that their homes will ever be worth more than the principal due on the mortgage is zero.
2. John and Mary are both up to date on their payments but considering just walking away because they have no stake in the outcome. Rents for comparable homes in their neighborhoods are a fraction of what they are paying monthly now on a mortgage based upon a false appraisal value.
3. In those states where mortgages are officially or unofficially “non-recourse” they can’t be sued for the loss that the bank takes on repossession, sale or foreclosure.
4. John and Mary find out about each other and enter into the following deal:
5. First, John and Mary enter into 15 year lease wherein Mary takes possession of John’s house and pays $1,000 per month in a net-net lease (Tenant pays all expenses — taxes, insurance, maintenance and utilities). There are some laws around (Federal and State) that state that even if the house is foreclosed, the “Buyer” must honor the terms of the lease. But even in those jurisdictions where the lease itself is subject to being foreclosed, John and Mary agree to RECORD the lease along with an option to purchase the house for $250,000 (fair market value) wherein the seller takes a note for the balance at a 3% interest rate amortized over 30 years.
6. So now Mary can have possession of the John house under a lease like any tenant. And she has an option to purchase the house for $250,000. And it’s all recorded just like the state’s recording statutes say you should.
7. Second, John and Mary enter into a 15 year lease wherein John takes possession of Mary’s house and pays $1,000 per month in a net-net lease (Tenant pays all expenses — taxes, insurance, maintenance and utilities). There are some laws around (Federal and State) that state that even if the house is foreclosed, the “Buyer” must honor the terms of the lease. But even in those jurisdictions where the lease itself is subject to being foreclosed, John and Mary agree to RECORD the lease along with an option to purchase the house for $250,000 (fair market value) wherein the seller takes a note for the balance at a 3% interest rate amortized over 30 years.
8. So now John can have possession of the Mary house under a lease like any tenant. And he has an option to purchase the house for $250,000. And it’s all recorded just like the state’s recording statutes say you should.
9. Third, John and Mary enter into a sublease (expressly permitted under the terms of the original lease) where in John (or his wife or other relative) sublet the John house from Mary for $1100 per month.
10. So John now has rights to possession of the John house under a sublease. In other words, he doesn’t move.
11. Fourth John and Mary enter into a sublease (expressly permitted under the terms of the original lease) where in Mary (or her husband or other relative) sublet the Mary house from John for$1100 per month.
12. So Mary now has rights to possession of the Mary house under a sublease. In other words, she doesn’t move.
13. Fifth, under terms expressly allowed in the lease and sublease, John and Mary SWAP options to purchase and record that instrument as well as an assignment.
14. So now John has an option to purchase the home he started with for $250,000 and Mary has an option to purchase the home she started with for $250,000 and both of them are now tenants in their own homes.
15. Presumably under this plan eviction or unlawful detainer is not an option for anyone claiming to be a creditor, wanting to foreclose. Obviously you would want to consult with a very knowledgeable property lawyer licensed in the appropriate jurisdiction before launching this strategy.
16. In the event of foreclosure, even in a non-judicial state, would be subject to rules requiring a judicial foreclosure which means the pretender lender would be required to plead and prove their status as creditor and their right to collect on the note and foreclose on the mortgage.
17. Meanwhile, after all their documents are duly recorded, John and Mary start paying rent pursuant to their sublease and stop paying anyone on the mortgages.
18. Any would-be forecloser would probably have a claim to collect that rent, but other than that they are stuck with a house where they got title (under dubious color of authority) without any right to possession (unless they prove a case to the contrary — the burden is on them).
19. If you want to slip in a poison pill, you could put a provision in the lease that in the event of foreclosure or any proceedings that threaten dispossession or derogation of the lease rights, the lease converts from a net-net lease to a gross lease so the party getting title still gets the rent payment but now is required to pay the taxes, insurance and maintenance. Hence the commencement of foreclosure proceedings would trigger a negative cash flow for the would-be forecloser.
20. To further poison the well, you could provide expressly in the lease that the failure of the landlord or successor to the Landlord to properly maintain tax, insurance and maintenance payments on the property is a material breach, triggering the right of the Tenant to withhold rent payments, and triggering a reduction of the option price from $250,000 to $125,000 with the same terms — tender of a  note, unsecured, for the full purchase price payable in equal monthly installments of interest and principal.

Not much difference than the chain of securitization is it?

Underwater, but Will They Leave the Pool?

MUCH has been said about the high rate of home foreclosures, but the most interesting question may be this: Why is the mortgage default rate so low?

After all, millions of American homeowners are “underwater,” meaning that they owe more on their mortgages than their homes are worth. In Nevada, nearly two-thirds of homeowners are in this category. Yet most of them are dutifully continuing to pay their mortgages, despite substantial financial incentives for walking away from them.

A family that financed the entire purchase of a $600,000 home in 2006 could now find itself still owing most of that mortgage, even though the home is now worth only $300,000. The family could rent a similar home for much less than its monthly mortgage payment, saving thousands of dollars a year and hundreds of thousands over a decade.

Some homeowners may keep paying because they think it’s immoral to default. This view has been reinforced by government officials like former Treasury Secretary Henry M. Paulson Jr., who while in office said that anyone who walked away from a mortgage would be “simply a speculator — and one who is not honoring his obligation.” (The irony of a former investment banker denouncing speculation seems to have been lost on him.)

But does this really come down to a question of morality?

A provocative paper by Brent White, a law professor at the University of Arizona, makes the case that borrowers are actually suffering from a “norm asymmetry.” In other words, they think they are obligated to repay their loans even if it is not in their financial interest to do so, while their lenders are free to do whatever maximizes profits. It’s as if borrowers are playing in a poker game in which they are the only ones who think bluffing is unethical.

That norm might have been appropriate when the lender was the local banker. More commonly these days, however, the loan was initiated by an aggressive mortgage broker who maximized his fees at the expense of the borrower’s costs, while the debt was packaged and sold to investors who bought mortgage-backed securities in the hope of earning high returns, using models that predicted possible default rates.

The morality argument is especially weak in a state like California or Arizona, where mortgages are so-called nonrecourse loans. That means the mortgage is secured by the home itself; in a default, the lender has no claim on a borrower’s other possessions. Nonrecourse mortgages may be viewed as financial transactions in which the borrower has the explicit option of giving the lender the keys to the house and walking away. Under these circumstances, deciding whether to default might be no more controversial than deciding whether to claim insurance after your house burns down.

In fact, borrowers in nonrecourse states pay extra for the right to default without recourse. In a report prepared for the Department of Housing and Urban Development, Susan Woodward, an economist, estimated that home buyers in such states paid an extra $800 in closing costs for each $100,000 they borrowed. These fees are not made explicit to the borrower, but if they were, more people might be willing to default, figuring that they had paid for the right to do so.

Morality aside, there are other factors deterring “strategic defaults,” whether in recourse or nonrecourse states. These include the economic and emotional costs of giving up one’s home and moving, the perceived social stigma of defaulting, and a serious hit to a borrower’s credit rating. Still, if they added up these costs, many households might find them to be far less than the cost of paying off an underwater mortgage.

An important implication is that we could be facing another wave of foreclosures, spurred less by spells of unemployment and more by strategic thinking. Research shows that bankruptcies and foreclosures are “contagious.” People are less likely to think it’s immoral to walk away from their home if they know others who have done so. And if enough people do it, the stigma begins to erode.

A spurt of strategic defaults in a neighborhood might also reduce some other psychic costs. For example, defaulting is more attractive if I can rent a nearby house that is much like mine (whose owner has also defaulted) without taking my children away from their friends and their school.

So far, lenders have been reluctant to renegotiate mortgages, and government programs to stimulate renegotiation have not gained much traction.

Eric Posner, a law professor, and Luigi Zingales, an economist, both from the University of Chicago, have made an interesting suggestion: Any homeowner whose mortgage is underwater and who lives in a ZIP code where home prices have fallen at least 20 percent should be eligible for a loan modification. The bank would be required to reduce the mortgage by the average price reduction of homes in the neighborhood. In return, it would get 50 percent of the average gain in neighborhood prices — if there is one — when the house is eventually sold.

Because their homes would no longer be underwater, many people would no longer have a reason to default. And they would be motivated to maintain their homes because, if they later sold for more than the average price increase, they would keep all the extra profit.

Banks are unlikely to endorse this if they think people will keep paying off their mortgages. But if a new wave of foreclosures begins, the banks, too, would be better off under this plan. Rather than getting only the house’s foreclosure value, they would also get part of the eventual upside when the owner voluntarily sold the house.

This plan, which would require Congressional action, would not cost the government anything. It may not be perfect, but something like it may be necessary to head off a tsunami of strategic defaults.

Filed under: bubble, CDO, CORRUPTION, currency, Eviction, foreclosure, GTC | Honor, Investor, Mortgage, securities fraud | Tagged: $800 fee, ARIZONA, Booth School of Business, CALIFORNIA, Department of Housing and Urban Development, Eric Posner, fee for non-recourse option, Lease, Luigi Zingales, mortgage default, New York Times, non-recorse, Option, pool, recording, Richard Thaler, strategic defaults, sublease, Susan Woordward, swap, University of Chicago, walking away | 19 Comments »