Why Felix Should Walk Away

March 5, 2009

"Felix" means lucky, in Latin. But this Felix hasn’t had much luck: after investing a whopping 50% downpayment into his $600,000 California dream home, he’s seen the value of his house fall to $270,000, even as the amount outstanding on his mortgage has ballooned to $350,000, putting him among the 8.3 million Americans with negative equity. This is what CNBC calls a "Dollar Dilemma":

Felix asks, quite sensibly, why he shouldn’t just walk away from his house. California is a non-recourse state, which means that the lender, was fully aware from day one that if the value of the mortgage ever exceeded the value of the house, there would be a strong financial incentive for the borrower to do just that.

The reaction of the CNBC hosts makes it seem as though Felix had asked whether he should sell his grandmother into slavery. "If you agreed and you signed that contract, you have to stick to it," admonishes Carmen Wong Ulrich. "It’s all about that commitment that you made to the house."

To the house? How can anybody make a commitment to a house? I can see that Felix signed a contract with a lender, but remember that the lender was writing negative-amortization interest-only mortgages and then turning around and selling them off to an investment bank to securitize, pocketing an up-front profit. Such lenders kept on making this trade until there was no more appetite for such loans any more, at which point they closed their doors, keeping all their old profits and leaving the losses with the investment banks and the banks’ clients.

So I don’t think that Felix has any kind of moral obligation to the lender, nor to the sophisticated financial institutions which ended up buying the lenders’ mortgages and who should have known exactly what they were doing.

I’ve quoted Mark Gimein on this subject in the past, more than once, but he really did write the best single blog entry when it comes to such matters, so I’d urge Felix to listen to Mark rather than to the shills of the financial-services industry on CNBC. Mark explains the morality of the situation very well, and ends with a bit more on how such decisions are likely to play out in practice:

Journalists are mistaken when they imagine that a credit score is a judgment on the character of borrowers. It’s not. It’s a judgment about the likelihood of someone repaying a loan. Bad marks like a foreclosure affect this. But being overextended on credit affects this even more. You might imagine that if you have the magic word "foreclosure" on your record you are automatically a worse risk than someone who doesn’t. That’s just not true. Lenders don’t like to lend money to people who have not paid their debts in the past. But what they like even less is lending money to people who have a mortgage they can’t afford and are likely to stop paying their debts in the future.

Now there might be good reasons for Felix to stay in his home: for one thing, he can happily continue paying interest only and no principal for another year or so, which wouldn’t harm him very much. And, of course, this is his dream house: if he rents somewhere else, he probably won’t be as happy with his home. But his wife is urging him to just walk away, and a happy wife is always a good thing.

The CNBC hosts, however, get unbelievably holier-than-thou with Felix, accusing this man — who, remember, has just lost his entire $300,000 downpayment — of profligacy and of trying to beggar his neighbors by bringing down property values even further.

At the very least, I think that Felix should consider a strategic delinquency, when his interest-only period expires. If the servicer isn’t talking to him now, then they surely will after receiving no mortgage payments for a couple of months. At that point, he can request a large principal reduction and make a credible threat that if he doesn’t get it, he’ll mail in the keys to the house. And if the servicer is sensible, they’ll give him what he’s asking for. They hold no cards at all in this negotation — although they do seem to have done a magnificent job with the CNBC types.

Reprinted from Portfolio.com

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