Go Ahead, Walk Away From That Underwater Mortgage

The history of the recent mortgage boom is one of bankers racing to outdo one another in lending more money on the basis of ever-flimsier collateral. This is not a new phenomenon. It is a speculative mania, as has appeared in real estate time and again, and one reason for the restrictions on banks collecting the full face value of busted mortgages is to make it less common. These restrictions on banks are not some newfangled innovation. California's one-action rule, for instance, dates back to 1860, a period during which ranchers bid up the price of land, thanks to easy backing from lenders who encouraged speculation in the hope of quick returns. Even the term walkaway is by no means new—it appears in this nearly 50-year-old (and lecture-free) story from Time, which cautions bankers that if they keep making careless mortgages they'll have to deal with debtors who abandon them.

That old news story has things exactly right. It's banks, not home buyers, that are in the better position to judge the real estate market and how much their collateral is really worth. The bank approves the assessment and decides how much equity a home buyer will be required to put up. All the mechanics of mortgages are designed to let a lender avoid the situation in which it is owed more on a house than it is worth. The limits on banks' ability to collect on badly underwritten mortgages places the responsibility for judging the sanity of real estate loans in the hands of lenders.

Clearly in the last few years all these mechanisms failed utterly. They failed, not because of morally bankrupt borrowers who go back on their “promises,” but because bankers decided to count on a perpetually rising real estate market to absolve them of the necessity of responsible lending. Far from misusing the lending laws, borrowers who use the rights the law gives them to walk away from mortgages merely place the risks of insane lending where the law intends them to lie. What they do is not dishonest; on the contrary, a key reason we give borrowers the ability to do that is to keep bankers honest and responsible.

In periods of market insanity, this doesn't work. But don't blame the walkaways for exercising their rights. Blame the bankers who didn't worry about lending a whole lot more than they could get back in a foreclosure. The lesson of watching debtors walk away is a harsh one (not least for the taxpayers, who now effectively guarantee most mortgages), but the more bankers pay attention to it now, the better their chances of steering clear of the next bubble.