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Jack M. Guttentag The Mortgage Professor

Jack M. Guttentag, The Mortgage Professor

Mortgage Fright and Moral Quandaries

by Jack M. Guttentag

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Posted on Wednesday, October 22, 2008, 12:00AM

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 to fear 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 two letters below are from borrowers who do not have a problem with their current mortgages but are distressed about what might happen in the future.

"Crazy Things Are Happening"

"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.

A Rate Is Adjustable -- Not the Index

"When the rate on my ARM (adjustable-rate mortgage) adjusts next year, the new rate should be the one-year Treasury rate at the time, plus a margin of 2.5 percent. Last year, however, my lender replaced the Treasury rate on new loans with Libor. Because of the crisis, Libor is now 2.5 percent 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.

When a Borrower Is Upside Down

I wish I could answer the next letter with the same degree of certainty.

"We bought our house just last year with 100 percent 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.

My right-handed side 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 side 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.

Finally, there is a policy dimension. Upside down borrowers would be encouraged to stay the course if they had some reason to believe that the government will help them get right side up. Right now, the prospects for this are extremely murky. But don't write the possibility off just yet.

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220 Comments

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  • Yahoo! Finance User - Thursday, January 15, 2009, 8:29PM ET  Report Abuse

    • Overall: 2/5

    NO WAY should the government get someone rght side up when the are upside down on their loan. They borrowed it - they owe it

  • Elmer - Sunday, November 9, 2008, 8:57PM ET  Report Abuse

    • Overall: 1/5

    You should pay your mortgage because you agreed to pay it. If you are in an upside down mortgage you should still pay it. You should not wait around for government to come in and help. What terrible advice! Where is our pride in ourselves? The market will come back, it may take 5 or even 10 years but it will come back. We need to work on developing pride back in ourselves and this means taking our lumps sometimes. This type of advice is exactly why we are in this situation and why the new administration will only make it worse.

  • Yahoo! Finance User - Saturday, November 1, 2008, 3:15PM ET  Report Abuse

    • Overall: 3/5

    Homeowners have a fiduciary responsibility as agreed to in their mortgage agreement etc. If for some reason, whether in their control or out of their control, the howeowner cannot or will not meet that obligation, it is the lendors option to forclose and take possession of the property. That's BIZ! However if the lenders were as smart as they think they are they would stop crying in their milk and take advantage of the situation. The lenders could make a deals with the homeowners something like this: Make an agreement with the homeowner that the lender will take back the property and lease the property back to the homeowner for a specified short term of 3-5-8-10 years or something, at a lease payment amount that the homeowner can easily afford. The lender marks the property to actual market and gets to take a loss against current income. The lendor still has an income producing asset on it's books with @75% value but also collecting lease payment income qualifying for depreciation deductions as well to offset current income. The homeowner agrees to fulfill the lease obligation by making payments for the full term of the lease etc. and the bank will not report forclosure proceedures or whatever preserving the homeowners credit rating so long as he fulfills lease. When the lease is up in the future and the real estate market stabilizes, the lendor might be able to re-mortgage the property back to the homeowner at a reduced value basis. The reduced basis would be based on the sum of all value that the lender accumulated through lease income, depreciation, and the original capital loss written off ect. from the original mortgage amount. Maybe??? This sounds more complicated than it is and the details would have to be worked out of course to make sure that it could work for both parties. - This is just agreement restructuring and accounting - The lenders could still come out clean long term. Just a quick thought....

  • Yahoo! Finance User - Wednesday, October 29, 2008, 5:13PM ET  Report Abuse

    • Overall: 1/5

    Are you also proposing everyone upside down on their car loans should hand in their keys. Give me a break. No wonder this country is in the tank.

  • Ken - Tuesday, October 28, 2008, 12:34PM ET  Report Abuse

    • Overall: 3/5

    Just my thought on a NEW BAILOUT IDEA... Why can't the government help everyone else instead of the people who are in trouble? Imagine this... through government intervention, which is already in place with the $700B bailout, 1. GOV'T SPONSORED LENDING: Working through banks, force the 30 yr mortgage lending rate to 1 or 2% for everyone using taxpayer money. It may even work with 3%, but please keep reading. 2. Allow people to refi if they wish to do so. 3. ENSURE THE TERMS ARE RESONABLE AND THAT PEOPLE CAN REPAY. 20% down etc. 4. Ensure banks will not make too much on the easy money with their crazy fees, but will make enough to stay in business. 5. REGULATE THE CRAP OUT OF IT SO IDIOT BANKS DONT END UP WHERE THEY WERE AGAIN!!!!!!!!!!!! 6. Probably other things will need to be in place, but this is the main idea. BENEFITS: 1. 95% of people with good credit and good standing can refi legally without ruining the credit system. this gives money to the economy to get restarted. 2. This will bring buyers out of the woodwork to buy new houses. 3. This will keep a % of the foreclosures from happening because the borrowers could refi into more reasonable terms. 4. MORE CHANCE "THE PEOPLE" GET PAID BACK WITH THEIR TAX MONEY AT RISK. It will guarantee that money will likely get paid back to the people UNLIKE the current $700B bailout. 5. There are plenty more benefits, too many to list here. 2nd way to implement this idea: You could even do the GOV'T SPONSORED LOANS in steps by starting at 5% and see where it goes, if it is not enough drop to 4%, then to 3% and keep dropping until the refi biz can get the economy back on its feet. In this 2nd scenario, the kicker will be that borrowers will not know how low the gov't will go thus spurring refi's at every level until the economy picks up. It may never have to reach 2%.

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