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Why You Should Love Homeowner Defaults

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Henry Ford did it. Walt Disney had to do it. Even Sam Walton went through it. Yet with so many eventual success stories coming from people who hit rock bottom financially and took advantage of bankruptcy protection rather than repaying their debts, why are today's homeowners getting treated like garbage for walking away from their underwater mortgages?

Few things provoke more controversy these days than homeowners who decide that they're too far in debt on their homes ever to pay off their mortgages. Yet while many turn financial decisions into a hotbed of moral argument, it's America's protection of those who fail financially that has given some of the country's best-known entrepreneurs the courage and support they needed in order to succeed eventually.

The ultimate safety net
Historically, those who couldn't pay off their debts were dealt with harshly. Debtors' prisons existed solely for borrowers who didn't repay their creditors, and extreme physical punishments were often imposed.

Against that backdrop, the U.S. system of bankruptcy stands out for its relative leniency on debtors. The Constitution called for Congress to establish uniform federal bankruptcy laws, and although several fits and starts resulted in temporary bankruptcy laws, it wasn't until 1898 that a permanent bankruptcy code took its place in American law.

The idea behind today's federal bankruptcy laws is simple: By giving relief to borrowers who have little or no chance to recover from their financial difficulties, bankruptcy provides a fresh start to those who would otherwise likely spend the rest of their lives in futile attempts to repay their debts. Although you'll always be able to find some who abuse the bankruptcy system, both creditors and debtors alike have full knowledge that the system exists -- and each should structure its finances accordingly.

Encouraging risk
The availability of bankruptcy protection also acts as a powerful incentive. When individuals and businesses know that they can start over in the event of a cataclysmic financial event, then they can afford to take much greater risks than they would if they had to bear the full cost of potential failure themselves.

In addition, bankruptcy can resurrect companies from an early grave. PG&E's Pacific Gas & Electric utility subsidiary filed for bankruptcy protection in early 2001 and took years to restructure its debts. Yet even the original shareholders didn't lose out, as the stock rose from a low of $6.50 during the bankruptcy proceedings to its current level around $44. Similarly, USG faced liability problems related to potential asbestos exposure, yet the stock went from $4 to as high as $100 before falling back in the aftermath of the housing bust.

More often, of course, bankruptcy is far from a win-win scenario. Shareholders of General Motors, for instance, emerged with nothing, and even bondholders didn't get full recoveries. Bankruptcy wiped out previous Kmart shareholders in 2002, but Eddie Lampert gained control of the post-bankruptcy company and rode strong share gains to buy out rival Sears and created Sears Holdings a couple years later.

Entire industries have stayed afloat with the aid of bankruptcy. Among airlines, for instance, US Airways has gone through bankruptcy multiple times. Several other major airlines, including Delta in 2005, have had to file at least once.

Dealing with homeowners
Against this backdrop, does it really make sense to demonize homeowners who walk away from their mortgages? Even though Wells Fargo (NYSE: WFC  ) , Bank of America (NYSE: BAC  ) , and other institutions that served hard-hit real estate markets suffered big losses, they certainly must have understood the risks involved in making nonrecourse mortgage loans.

With no incentive to pay off underwater mortgages and every incentive to get the fresh start offered by walking away, mortgage borrowers are simply making the economic choices that countless individuals and corporations have made before them. And in fact, letting homeowners get a quick fresh start rather than forcing them to linger in financial difficulty for years or even decades is the fastest way to stimulate a true recovery.

Before you conclude that underwater homeowners are all immoral for choosing to breach their contracts and give up on their obligations, consider that bankruptcy laws that have existed for more than a century have long given borrowers similar rights. There will always be winners and losers when debtors give up the ghost. But overall, experience has shown that leniency in bankruptcy does more good than harm for society as a whole. That's arguably one of the most important success stories of the American experiment.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger isn't underwater ... yet. He doesn't own shares of the companies mentioned in this article. USG is a Motley Fool Inside Value pick. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy gives you all the options.


Read/Post Comments (7) | Recommend This Article (13)

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  • Report this Comment On May 19, 2010, at 6:44 PM, kedo76 wrote:

    Great article, but I would debate one thing:

    "Even though Wells Fargo (NYSE: WFC), Bank of America (NYSE: BAC), and other institutions that served hard-hit real estate markets suffered big losses, they certainly must have understood the risks involved in making nonrecourse mortgage loans."

    I don't think anyone did. With banks always foreclosing on someone in the past and then selling at a profit, I don't think banks ever thought they would be in this situation; to foreclose and take loss after loss, things now being on the side of the homeowner.

  • Report this Comment On May 20, 2010, at 8:32 AM, TicoHombre wrote:

    Here we go again...

  • Report this Comment On May 20, 2010, at 11:27 AM, AnotherNavyFool wrote:

    Dan,

    I enjoy your articles, but I have to disagree with you on this one. Not only do I not love homeowner defaults, I loathe them.

    I agree the bankruptcy laws need to be there, but as a last resort for individuals and businesses who no other options. And for them, good - use the system the way it was intended to try to make the best of a bad situation.

    I reserve my venom for those who can pay their debts, but choose to walk away because they cannot keep up a lifestyle they want. We responsible homeowners are left holding the bag for their irresponsibility, short-sightedness, and selfishness through lower property values, tax-funded bailouts, and deteriorating conditions in our neighborhoods.

    Using a few examples of those who used bankruptcy and succeeded is a stretch. What about all those that failed to succeed after using it? ADM Nimitz went on to become a great admiral years after putting his ship on a sand bar, but how many officers were cashiered for the same mistake? And the system was different for Walton, Disney, Ford, and Nimitz (all over 50 years ago) when they hit bottom (literally!) before recovering. The rules are different now and the chances and methods of acheiving their kinds of success are less.

    The businesses cited as successful examples of using bankruptcy are good, but that is not how it works for individuals. Individual bankruptcies tend to be an "all or nothing" affair, at least where the house is concerned. I think it would be great if the banks had a better system to "restructure the debt" of an individual so they could make a comeback, just as the businesses did. And that is a key difference - the businesses went through it with the intention of coming back, not chucking it all for someone else to absorb the loss and just "start over" somewhere else.

    Again, however, I come back to the backward practice we seem to do in this country of continuing to reward those who make bad decisions and not helping (or even punishing) those who are doing the right thing. I would much rather see banks work with those who do make thier payments and are responsible instead of trying to save those who are mostly financial lost causes already. And those who walk away from their obligations when they can afford them need to have consequences for the failure to meet their legal obligations - perhaps blacklisted by lending institutions for life; they have shown they cannot be trusted even when they have the means to fulfill thier obligation. Why would you ever want to lend to them again? Both sides of the equation need to honor their word. I bet if the bank decided to just walk away from a situation that was beneficial for the borrower and "made good business sense" for the bank, the borrower would be upset and look to the law force recourse. Both sides made an agreement, both need to honor it. If we all start doing this, the system collapses.

    For my part, I am upside-down, but not badly, and can pay my bills. Could I have a better funded lifestyle if I walked away? Sure. But I am not moving so the "value" of my house is irrelevant right now. However, the value of my "home" as the place I raise my children and help mold them into responsible citizens and future leaders is priceless.

    And for you that can't see the moral implications of this, I feel sorry for you. Our word, our integrity must be worth more than a mortgage, yet only we can put a price on it. If it comes down to just dollars for you and you can live with yourself after making such a decision, so be it. That is your choice.

    I however, want nothing to do with you, your business, or your way of doing things. And that is my choice.

  • Report this Comment On May 20, 2010, at 12:57 PM, ValueIsValuable wrote:

    So, to sum up, when a business does it, it's "just business". When Joe Homeowner does it, it's immoral.

    That's a double standard, pure and simple.

  • Report this Comment On May 20, 2010, at 2:38 PM, AnotherNavyFool wrote:

    ValueisValuable: The standard I hold both to is keeping their end of the agreement. I understand there are situations where there is no choice for a business or individual to take but bankruptcy - as I stated. That is when the laws in place should be used, as a LAST choice, to make the best of a bad situation.

    I have a problem with homeowners who walk away when it is NOT the last option, but so they can keep up their lifestyle at the expense of neighbors and taxpayers. It's called keeping your word. If everyone stopped honoring their commitments just when convenient, we would be in a far worse state of affairs than now.

    Your statement holds no water - there is no double standard. You assume I expect businesses to act "morally" which I do not. I expect them make decisions based on the bottom line. I HOPE they act morally, but am not surprised when they don't. I expect individuals to act morally, however. And that is not to say there are not moral individuals that work at companies that make "immoral" decisions.

    When a business walks away, there are consequences - people are fired, shareholders lose investments, loss of confidence in the company, maybe even total collapse of the company. Possibly there should be more. I am saying that when an person makes that choice (when they still have the ability to pay), there should be consequences for them, too.

    The problem here is the definition of morals. Some would say it is immoral for a company to lay off people due to the chaos that creates in peoples' lives - to others it is just business. Others would say investing in "sin stocks" is immoral, others would say it is just business. Some say causing the recent oil spill in the Gulf is an immoral act, others say it is the price of extracting oil to feed our petroleum hungry economy. It all depends on your perspective.

    Both sides need to be better at keeping their word. Since I do not see Congress having the spine to pass laws to make it happen for the banking industry or indivuals (well, given the current climate, maybe they will for banks), then that leaves me with only the choices I can make. I choose not to do business with a company that acts in ways I disapprove of. I choose not to ineract with people who act in ways I disapprove of. Each will judge what the loss of my business, association, or friendship means to them. And if enough people choose the same way I do, the business or person will change their behavior. Or they can write me off.

    Either way, I am paying my mortgage because I gave my word I would and my integrity stays intact.

  • Report this Comment On May 20, 2010, at 3:33 PM, hbofbyu wrote:

    Amen to Navyfool. Looking only at the $$ of a situation is short-sighted. The foundation that has made America more successful than any country in history is the moral conciousness and rule of law established at its inception. Travel anywhere on this earth and you will see an increase in nepotism, back-door deals, bribes and general apathy towards the rules of the game (China and copyrights anyone?). I have lived in cultures where if something isn't locked up it is consider common property. Seriously! If a bicycle is left unattended there is no guilt and no shame in taking it for yourself. Commerce and business is seriously impeded where there is no trust between the parties involved.

    The U.S. is increasingly losing the shame and guilt that made this country great. (You may laugh at that statement.) But it was only 20-30 years ago when it was shameful to accept handouts from the governement. Nobody went on medicaid and nobody collected un-employment and if you declared bankruptcy you moved out of your neighborhood and sold your house.

    My company has seen our technology stolen and replicated by India and China and we have no economical recourse. Any policy (ie liberal bankruptcy laws) that encourages the abandonment of moral oblgations errodes trust and gradually changes our climate of commerce to the standards of a third world country.

  • Report this Comment On May 22, 2010, at 8:43 AM, dhtang8 wrote:

    +1 to AnotherNavyFool...agree with the protection as a last option for those attempting to create something. Innovation has been a key part of America's history and it makes sense have a reasonable safety net.

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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