Mortgage Fright and Moral Quandries
October 20, 2008, Revised November 6, 2008
The mortgage world has suddenly become very frightening to many people who have no real reason to be frightened. Their mortgages are in good standing, they are not having any trouble meeting their payments, yet they are in distress – in large part, because so many around them are in distress. Fear is contagious. The only antidote I know is good information.
One important thing that people suffering from mortgage fright often forget is that a mortgage loan is a contract between two parties, and it cannot be violated by either without the permission of the other. If the loan is sold, the purchaser replaces the originating lender as the contracting party and is subject to the contract in the same way. If the servicing of the loan is sold, the servicer as the agent of the owner is required to abide by the terms of the contract, and the same holds if the loan is placed in a pool as collateral for a mortgage-backed security.
The first two letters below are from borrowers who do not have a problem with their current mortgages but are distressed about possible changes to their mortgages in the future.
"Can whoever owns my mortgage demand immediate repayment of the balance? I know it doesn’t make sense but crazy things seem to be happening…"
Mortgage contracts do not give the lender the right to demand immediate repayment. Balloon loans require repayment at the end of the balloon period, but that is stated in the contract. Fortunately, there are not too many balloon loans around.
Even if lenders had the legal right to demand immediate repayment, they wouldn’t do it because it would only generate more foreclosures. For the same reason, borrowers with balloon loans in good standing who are unable to refinance anywhere else, will find that their existing lender will prefer to refinance them than to foreclose.
"When the rate on my ARM adjusts next year, the new rate should be the one-year Treasury rate at the time, plus a margin of 2.5%. Last year, however, my lender replaced the Treasury rate on new loans with Libor. Because of the crisis, Libor is now 2.5% higher than Treasury. Can my lender switch my ARM to Libor when my rate is adjusted?"
No way, the rate is adjustable but not the index used to calculate it. Your ARM contract stipulates the index and its source, and the only circumstance in which a different index can be substituted is in the event the specified index is no longer available. The different Treasury indexes used by ARMs are compiled by the Federal Reserve and there is zero likelihood that they will disappear.
I wish I could answer the next letter with the same degree of certainty.
"We bought our house just last year with 100% financing, now it is worth $40,000 less than we owe. I don't know what to do. Do we keep making mortgage payments or do we stop? A friend has advised us to lock the door and send the key to the lender, but that doesn't sit very well with me. We've always met our obligations and have good credit.. What do you advise?"
This letter is typical of many I have received from borrowers who are "upside down" in owing more than their houses are worth. I have a lot of trouble dealing with it because in good part it is a moral issue and my rabbinical credentials are weak.
My right-handed rabbi says that when you borrow money, you should pay it back if you can. During the many years when house prices were rising, he never once heard of a mortgage borrower offering to share the capital gain with the lender. There is no justification in forcing the lender to share the capital loss.
My left-handed rabbi rejoins that very few of the people who are upside down today enjoyed a capital gain on previous homes that they owned. Further, the borrower’s major obligation is to his family, not to his lender. If the financial gain from letting the house go to foreclosure more than offsets the pain of having their credit trashed and having to find a new place to live, then that is what the borrower should do.
There is an economic dimension to this quandary. If those who are upside down could be assured that house prices had hit bottom and within a year or two they will be right-side up, there is little doubt that most would elect to stay the course. Unfortunately, no economist in good conscience can provide such assurance today. Nonetheless, I believe that in most cases rational borrowers will decide that their best choice is to stay the course, making their payments and waiting for markets to recover.
Finally, there is a policy dimension. Upside-down borrowers would be further encouraged to stay the course if they had some reason to believe that the Government will help them get right-side up. There are policies in the planning stage at this writing to curb foreclosures by accelerating the pace of contract modifications. Stay tuned.
The mortgage world has suddenly become very frightening to many people who have no real reason to be frightened. Their mortgages are in good standing, they are not having any trouble meeting their payments, yet they are in distress – in large part, because so many around them are in distress. Fear is contagious. The only antidote I know is good information.
Mortgage Contracts Cannot Be Violated
One important thing that people suffering from mortgage fright often forget is that a mortgage loan is a contract between two parties, and it cannot be violated by either without the permission of the other. If the loan is sold, the purchaser replaces the originating lender as the contracting party and is subject to the contract in the same way. If the servicing of the loan is sold, the servicer as the agent of the owner is required to abide by the terms of the contract, and the same holds if the loan is placed in a pool as collateral for a mortgage-backed security.
The first two letters below are from borrowers who do not have a problem with their current mortgages but are distressed about possible changes to their mortgages in the future.
"Can whoever owns my mortgage demand immediate repayment of the balance? I know it doesn’t make sense but crazy things seem to be happening…"
Mortgage contracts do not give the lender the right to demand immediate repayment. Balloon loans require repayment at the end of the balloon period, but that is stated in the contract. Fortunately, there are not too many balloon loans around.
Even if lenders had the legal right to demand immediate repayment, they wouldn’t do it because it would only generate more foreclosures. For the same reason, borrowers with balloon loans in good standing who are unable to refinance anywhere else, will find that their existing lender will prefer to refinance them than to foreclose.
"When the rate on my ARM adjusts next year, the new rate should be the one-year Treasury rate at the time, plus a margin of 2.5%. Last year, however, my lender replaced the Treasury rate on new loans with Libor. Because of the crisis, Libor is now 2.5% higher than Treasury. Can my lender switch my ARM to Libor when my rate is adjusted?"
No way, the rate is adjustable but not the index used to calculate it. Your ARM contract stipulates the index and its source, and the only circumstance in which a different index can be substituted is in the event the specified index is no longer available. The different Treasury indexes used by ARMs are compiled by the Federal Reserve and there is zero likelihood that they will disappear.
I wish I could answer the next letter with the same degree of certainty.
The Moral Quandary of Those Upside Down
"We bought our house just last year with 100% financing, now it is worth $40,000 less than we owe. I don't know what to do. Do we keep making mortgage payments or do we stop? A friend has advised us to lock the door and send the key to the lender, but that doesn't sit very well with me. We've always met our obligations and have good credit.. What do you advise?"
This letter is typical of many I have received from borrowers who are "upside down" in owing more than their houses are worth. I have a lot of trouble dealing with it because in good part it is a moral issue and my rabbinical credentials are weak.
My right-handed rabbi says that when you borrow money, you should pay it back if you can. During the many years when house prices were rising, he never once heard of a mortgage borrower offering to share the capital gain with the lender. There is no justification in forcing the lender to share the capital loss.
My left-handed rabbi rejoins that very few of the people who are upside down today enjoyed a capital gain on previous homes that they owned. Further, the borrower’s major obligation is to his family, not to his lender. If the financial gain from letting the house go to foreclosure more than offsets the pain of having their credit trashed and having to find a new place to live, then that is what the borrower should do.
There is an economic dimension to this quandary. If those who are upside down could be assured that house prices had hit bottom and within a year or two they will be right-side up, there is little doubt that most would elect to stay the course. Unfortunately, no economist in good conscience can provide such assurance today. Nonetheless, I believe that in most cases rational borrowers will decide that their best choice is to stay the course, making their payments and waiting for markets to recover.
Finally, there is a policy dimension. Upside-down borrowers would be further encouraged to stay the course if they had some reason to believe that the Government will help them get right-side up. There are policies in the planning stage at this writing to curb foreclosures by accelerating the pace of contract modifications. Stay tuned.