The price goes up, it goes down…all around the town. Sorry. Hindsight, they say, is 20/20. So, in retrospect, it is not so surprising that the boom in real estate prices of just a few years ago was followed by a painful collapse. Encouraged by low interest rates and a willingness of banks to lend money to almost anybody, many people had jumped into the housing market, sometimes buying expensive homes with mortgages they could barely afford, based on the belief, celebrated in televisions shows like “Flip This House,” that housing prices would continue to go up and up and up. But the law of gravity applies to housing prices, too, it seems. Inevitably, the housing market cooled down, and housing prices stopped rising; then they slowly reversed direction and began steadily declining. As a result, many people found themselves making mortgage payments on homes worth far less than what they had originally paid for them. Moreover, many of them had been talked into taking mortgages they didn’t really understand, for example, mortgages with adjustable rates or with special “balloon” payments due after a few years, or that were too expensive for them to afford in the first place. The financial crisis of 2008 and the recession that followed only made things worse. Faced with monthly payments they could no longer sustain, these borrowers lost their homes through foreclosure. 

Widespread foreclosures, in turn, drove housing prices even lower, leaving more and more homeowners—by 2010 an estimated 5.4 million of them—“under water,” that is, with mortgage balances at least 20 percent higher than the value of their homes. Consider thirty-year-old software engineer, Ron Smith. He paid $340,000 for a home in the Phoenix suburbs. Two years later, its value had dropped to less than $230,000, but he still owed the bank $318,000. As a result, Smith decided to stop paying his mortgage, defaulted on his loan, and walked away from his home. Or consider Tim Brown. He paid $215,000 for an apartment in Miami Beach, which three years later was worth only $90,000. Although still paying his mortgage, he is thinking about following Smith’s example. What distinguishes Smith and Brown from many other homeowners whose homes are under water or who are in mortgage trouble is that both have good jobs and could afford to keep making their monthly payments—if they chose to. Moreover, they are smart guys and knew what they were doing, or thought they did, when they bought their homes. However, figuring that it would take years for their properties to regain their original value and that renting would be cheaper, they are among a growing number of homeowners who have either walked away from their mortgages or are considering it, not out of necessity, but because doing so is in their financial interest. Experts call this “strategic default.” Or, in the words of an old Paul Simon song, “Just drop off the key, Lee, and get yourself free,”….well, maybe. As any financial advisor will tell you, there are lots of good reasons not to default on a mortgage. A foreclosure ruins a consumer’s credit record for seven years, and with a low credit score, one must pay a higher interest rate on auto and other loans. Moreover, some states allow lenders to seize bank deposits and other assets of people who default on mortgages. Tim Brown also 2 worries that skipping out on his mortgage might hurt him with a future employer or diminish his chance of being admitted to graduate school. Still, there’s no denying that for some borrowers simply mailing in the keys and walking away can make sense. 

But that leaves one question unanswered: Do they have a moral responsibility to meet their financial commitments? The standard mortgage-loan document that a borrower signs says, “I promise to pay” the borrowed amount. A promise is a promise, many people believe; they think you should keep making your mortgage payments even if doing so is inconvenient. In fact, 81 percent of Americans agree that it is immoral not to pay your mortgage when you can. Frank Mills, a professor of business ethics, is one of them. He maintains that if you were not deceived by the lender about the nature of the loan, then you have a duty to keep paying. If everybody walked away from such commitments, he reasons, the result would be disastrous. As Paul Rega, a finance professor, points out, each strategic default emboldens others to take the same step, which he describes as a “cascade effect” with potentially damaging consequences for the whole economy. Economist George Vanden adds that these borrowers were not victims. They “signed contracts, and as adults should be held accountable.” Others disagree. David Gill, a law professor, says that homeowners should base the decision whether to keep paying or walk away entirely on their own interests “unclouded by unnecessary guilt or shame.” They should take their lead from the lenders, who, he says, “ruthlessly seek to maximize profits or minimize loss irrespective of concerns of morality or social responsibility.” People who think like Professor Gill also argue that the banks fueled the housing boom in the first place by loaning money, based on unrealistic appraisals of home values, to people who were unlikely to be able to keep up their payments in order to resell those loans to other investors. Others suspect a double standard. Homeowners are criticized for defaulting but businesses often declare bankruptcy even when they have money in the bank and could keep paying their bills. In fact, doing so is often thought to be a smart move because it trims their debt load and allows them to break their union contracts. Tim Brown, for his part, remains conflicted. “People like me are beginning to feel like suckers. Why not let it go in default and rent a better place for less?

There is no financial sense in staying.” Still, he struggles with the ethical side of the question: “I took a loan on an asset that I didn’t see as overvalued,” he says. “As much as I would like my bank to pay for that mistake, why should it?” Aaron Houser, chief executive of the Mortgage Bankers Association, concurs with this. In addition, he says, defaulting on your mortgage and letting your home go into foreclosure hurts the whole neighborhood by lowering property values. He adds: “What about the message they still send to their family and their kids and their friends?” 3 For his part, John Smith admits that defaulting was the “toughest decision I ever made.” Still, he faced a “claustrophobic situation,” he says, because if ever he lost or quit his job, he would have been unable to sell his house and move somewhere else. Moreover, he says, lenders “manipulated” the housing market during the boom by accepting dubious appraisals. “When I weighed everything,” he says, “I was able to sleep at night.” U.S. foreclosure rates from 2005-2014, in percentages Additional Considerations: Countrywide Financial’s involvement in creating a worldwide recession Many consider subprime loans (predatory lending practices, liar loans) to be a key contributor to the 2008–2009 financial crisis. While Countrywide was certainly involved in subprime lending and predatory lending practices among other things, it was not the only cause of the financial crisis. Numerous other Wall Street companies were investigated for unethical practices related to this scandal. (The list includes Bank of America, which has been investigated for potential breaches of fiduciary duty concerning employee retirement funds.) 

However, Countrywide’s unethical behavior was a key contributor to the problems in the economy during 2008–2009. Many consider it to be one of the central villains in this crisis. They allege that Countrywide knowingly engaged in risky loans and offered subprime loans even to those who qualified for regular loans in order to profit from the higher rates. In the process, it may have helped to falsify lender information, allowing those with no assets to obtain loans. The consequence was a surplus of housing, plummeting housing prices, and a slew of foreclosures, all of which placed the economy in a precarious state. The United States lost global credibility as an economic leader of the free world. The Countrywide scandal has brought up other issues, including that of executive compensation. Should executives receive hefty compensation packages and severance pay when their companies flounder? Should they be called to account for not exercising due care? Many people think so, as evidenced by the enormous public outrage. It is clear that Countrywide failed the majority of its stakeholders. Ethical misconduct and high-risk business practices helped to create the disaster at Countrywide, and was a substantial contributor to the worldwide financial disaster that occurred.

What would you do if you were in Smith’s or Brown’s situation? What factors would you consider?

Do people have a moral obligation to repay money that they borrow, as Professor Mills thinks, or is this simply a business decision based on self-interest alone, as Professor Gill thinks?

“It is morally permissible for homeowners whose homes are underwater to default on their mortgages even if they could continue to pay them.” What arguments do you see in favor of this proposition? What arguments do you see against it?

Are the banks responsible for the housing boom that enticed people to buy homes at inflated prices? If so, does this affect whether you have an obligation to repay your loan? What about Professor Gill’s contention that the banks themselves care only about maximizing profit?

When first popularized, the financial tool of subprime loans was praised for lowering barriers to home ownership. The U.S. Department of Housing and Urban Development stated that subprime loans were helping many minorities afford homes and were therefore a good tool. This resulted in minorities being targeted by the predatory lending practices of institutions (as in the case of the Countrywide predatory lending scandal). Would this knowledge change any of your answers? Explain why or why not. Should financial institutions be held responsible for this? What about the U.S. Department of Housing and Urban Development?