Borrowers and lenders behaved badly during the bubble. Some were unethical and some were immoral. Today we examine these distinctions to see what we can learn from their mistakes.
Irvine Home Address … 14522 MANGO Ave Irvine, CA 92606
Resale Home Price …… $649,000
And it used to be for a while
That the river flowed right to my door
Making me just a little too free
But now the river doesn't seem to stop here anymore
Carly Simon — The Right Thing to Do
Did anyone who participated in the Great Housing Bubble stop to consider what was the right thing to do? As long as the money flowed in a river to homeowner's doors, few cared. The river of free money isn't flowing any more, and now we have to examine why this happened, or we risk doing it again.
In yesterday's post on Walking Away from a Mortgage to Secure Their Children’s Future, I presented the argument that people should walk away from their mortgages if they are facing the choice between defaulting or paying on an underwater mortgage when renting is less expensive. The astute observations from that post are among the most interesting in recent memory at the IHB. Today, I want to recap some of the arguments made and delve deeper into this contentious issue.
Ethics and Morality
Finding a good definition of ethics or morals is difficult because the terms have different meanings in different contexts. For purposes of the discussion today, I will define morality as the individual's sense of right and wrong, and ethics as the code of conduct as defined by a group of people for common benefit. Ethics can change with the group and the circumstances whereas morality is consistent for the individual.
Also, consider this definition:
The difference between ethics and morals can seem somewhat arbitrary to many, but there is a basic, albeit subtle, difference. Morals define personal character, while ethics stress a social system in which those morals are applied. In other words, ethics point to standards or codes of behavior expected by the group to which the individual belongs. … So while a person’s moral code is usually unchanging, the ethics he or she practices can be other-dependent.
When considering the difference between ethics and morals, it may be helpful to consider a criminal defense lawyer. Though the lawyer’s personal moral code likely finds murder immoral and reprehensible, ethics demand the accused client be defended as vigorously as possible, even when the lawyer knows the party is guilty and that a freed defendant would potentially lead to more crime. Legal ethics must override personal morals for the greater good of upholding a justice system in which the accused are given a fair trial and the prosecution must prove guilt beyond a reasonable doubt.
The prosecution and court must also deal with the difference between ethics and morals. In some cases past actions of the accused might resonate with the current charge, but are kept out of evidence so as not to prejudice the jury. In a sense, the prosecutor “lies by omission” in representing the case, never revealing the prejudicial evidence. The same prosecutor, however, would likely find it reprehensible to fail to tell a friend if her date had a potentially dangerous or suspect history.
Another area in which ethics and morals can clash is at the workplace where company ethics can play against personal morality. Corporate greed that blurs its own ethical lines coupled with unreasonable demands on time can lead to having to chose between a stressful, demanding and consuming work ethic, and family obligations seen as moral obligations to spouse and children. Conversely, people lose jobs every day because of poor personal morals, employee theft being a common reason for dismissal.
As a society, when we pass laws, we make moral statements. We prohibit certain behaviors and permit others. Often we draw lines somewhere in the ethical shades of gray. There are a great many unethical behaviors that are not illegal or immoral. IMO, all consumer lending is inherently immoral, but society has stated is it not illegal, so it goes on.
Ethics and Morality in Lending
Lending has its own code of ethics. Lenders underwrite loans based on the representations from buyers that they will repay the money. If borrowers do repay, they are considered an ethical borrower, and they are extended easy credit. If borrowers do not repay, they are considered unethical borrowers, and they are not extended easy credit.
Lenders spend much time and effort trying to accurately measure borrower ethics. This measurement system is encapsulated in the FICO score. Those borrowers that pay their bills on time and in full have very high FICO scores. Those borrowers that do not pay on time have very low FICO scores. I consider this in the realm of ethics because it is nothing more than a measurement of how likely a borrower is to play by the rules of the game. FICO scores have nothing to do with morality.
Lending between friends and family members generally does carry a moral obligation. Friends loan money because they are friends, not because it is a carefully considered, arm’s-length business transaction. The friend is not motivated by profit, and they are not weighing the risks involved. They are relying on the borrower's moral duty to repay, and the borrower is appealing to that moral duty. The friendship is the basis for the loan and the moral obligation. (This is also why you should never loan friends or family money.)
Banks and businesses loan money to make a profit. They are supposed to consider the risks and set the interest rate to obtain an appropriate level of profit. Lenders are also aware of their contractual fallback positions or legal action, repossession and so on. If a borrower fails to pay back a loan, lenders will exercise their legal, contractual rights and try to get repaid. Lenders will also warn other lenders of the borrower behavior through credit reporting. This is lender ethics. Morality does not enter into the equation.
Breaking the ethical rules of lending may or may not be immoral. Most people who do not repay loans are unable to repay. Their ethics as measured by FICO would be lowered, but this does not diminish the character and morality of the borrower. If the intent was to repay, the borrower may have sterling character and still be considered unethical because they defaulted on a loan, particularly if the reason the borrower cannot repay is because the lender loaned them too much money under terms the borrower did not understand. (That defense is used too often, but in rare cases, it is accurate.)
Ethics Versus Morality: Strategic Default
Strategic default is a conscious choice by a borrower to behave unethically by the rules of the lending agreement, and the borrower is going to suffer the consequences through a lower FICO score and diminished access to credit in the future. In yesterday's post, I argued that his behavior is not immoral because the borrower has other moral obligations that outweigh their ethical concerns. Strategic default is unethical, but it is not immoral.
Strategic defaulters have to make a choice: do they fulfill their ethical duty to repay the loan, or do they fulfill their moral duty to provide for their family? These people will pay a price for their decision to walk: they will lose their homes, and they will have limited access to credit in the future. IMO, it is still the right choice for the family because their moral obligation is greater than their ethical one.
The people facing the ethics versus morality decision are not responsible for what happens to banks or the US taxpayer who is being compelled to pay for the loss. The banks should be allowed to go under, and the US taxpayer should not be responsible for paying the bill. That travesty of justice has nothing to do with the decisions of individual borrowers to walk away from their loans. It does piss me off that I have to pay for it, but I can’t call the defaulter’s immoral for doing what is best for their families. I can and do fault the lenders for creating this situation and the government for allowing it to happen, but what is done is done.
When lenders loan too much money to borrowers, they are behaving immorally. Lenders create the circumstances where borrowers are hopelessly in debt, then they churn them with fees and usurious interest rates and keep them in perpetual servitude. That is immoral. The borrower benefits in no way from this arrangement.
Lenders want borrowers to believe they have a moral obligation to repay them. To the degree that lenders convince borrowers they have a moral obligation to repay debts is the degree to which lenders exploit borrowers. If lenders knew their loans might not be repaid, they would loan less money, particularly for unsecured consumer goods. That would be a good thing. Prudent lending should always be secured by assets, and if that asset declines in value (like a car) then the loan should amortize faster than the depreciation.
When lenders do not face the consequences for foolish and immoral lending, they do more of it. That is moral hazard. In our current circumstances, lenders are being spared the pain of their foolishness because of misplaced borrower morality and a variety of government bailouts.
Ethics and Morality in Borrowing
When I wrote, HELOC Abuse Grading System, I discussed the fine line between gaming the system out of ignorance or out of malice. Intent matters, and those who knowingly gamed the system were immoral. All were unethical.
The borrowers were told they would never have to repay this debt because the house would pay for it. Either the borrowers would be offered serial refinancing with endless teaser rate payments, or some other borrower would pay off their debts when they moved to their next cash cow house. If these borrowers had believed they were going to have to pay these loans back from their wage income—something very few of them considered—then they were ignoring their obligation to their family; however, since borrowers never thought they would have to pay back these debts—a belief lenders fostered—then the immorality is really in the behavior of the lenders.
The end result of HELOC abuse is theft. Those that did it in ignorance—which was most of them—acted as thieves, but most of them did not set out to steal. At some level they thought somebody would come along, buy their overpriced house, and pay off the debt. A few of them knowingly took the money with malicious intent, and those people are immoral, the rest were just really stupid and they were enabled by really stupid lenders.
The borrowers were thieves. But the lenders encouraged them to steal in every way. Both parties were in the wrong, and now all of us who did not participate are having to pay the bills.
The whole cast of characters who participated in the housing bubble were unseemly. it is easy to create cartoons about these people because they were all unethical and immoral in one way or another. No matter how I represent them, if it is negative, it will resonate. The lenders, investors, realtors, mortgage brokers, borrowers, HELOC abusers, government regulators, the Federal Reserve, the Treasury department, everyone who was involved indirectly conspired to steal wealth from savers, renters and prudent homeowners who did not participate in the madness. Some were immoral, most were unethical, and all have benefited from their deeds at the expense of those who had nothing to do with it.
The Big Lie
The bankster bailouts did NOT save us from the second Great Depression. We could have wiped out all the equity and bond holders, recapitalized with taxpayer funds, then sold the public interest later. Sweden did this in the mid 90s, and it worked well. At the time the bailouts were engineered, there was no international treaty or procedure for discharging debt across international lines. The US Government could not force a foreign government to drop its claim to the foreign interests of an American bank in bankruptcy. Rather than try to figure out how to make that work, we decided to pay the bills of too-big-to-fail when it failed. Of course, now that the crisis has past, lenders are lobbying to prevent financial reform that may diminish their paychecks.
Our government is participating in a mockery of the principles of fairness and morality this country was founded on. We now have an out-of-control financial sector sucking in the resources of the nation while providing little in return. In the years leading up to the 2008 crisis, the financial industry accounted for a third of total domestic profits — about twice its share two decades earlier.
I hope the government gets financial reform right. It is our only hope to counteract the moral hazard created by everything else the government has done….
Government reform is our only hope?
Irvine Home Address … 14522 MANGO Ave Irvine, CA 92606
Resale Home Price … $649,000
Home Purchase Price … $590,000
Home Purchase Date …. 11/15/2004
Net Gain (Loss) ………. $20,060
Percent Change ………. 10.0%
Annual Appreciation … 1.7%
Cost of Ownership
$649,000 ………. Asking Price
$129,800 ………. 20% Down Conventional
5.16% …………… Mortgage Interest Rate
$519,200 ………. 30-Year Mortgage
$136,840 ………. Income Requirement
$2,838 ………. Monthly Mortgage Payment
$562 ………. Property Tax
$0 ………. Special Taxes and Levies (Mello Roos)
$54 ………. Homeowners Insurance
$43 ………. Homeowners Association Fees
$3,498 ………. Monthly Cash Outlays
-$489 ………. Tax Savings (% of Interest and Property Tax)
-$606 ………. Equity Hidden in Payment
$264 ………. Lost Income to Down Payment (net of taxes)
$81 ………. Maintenance and Replacement Reserves
$2,748 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$6,490 ………. Furnishing and Move In @1%
$6,490 ………. Closing Costs @1%
$5,192 ………… Interest Points @1% of Loan
$129,800 ………. Down Payment
$147,972 ………. Total Cash Costs
$42,100 ………… Emergency Cash Reserves
$190,072 ………. Total Savings Needed
Baths: 2 full 1 part baths
Home size: 2,210 sq ft
($294 / sq ft)
Lot Size: 6,650 sq ft
Year Built: 1974
Days on Market: 8
MLS Number: S613431
Property Type: Single Family, Residential
According to the listing agent, this listing may be a pre-foreclosure or short sale.
PREMIUM cul de sac location on large lot with fully enclosed SUPERESIZED BACKYARD!! Soaring vaulted ceilings, upgraded laminate flooring and full bedroom and bath on FIRST LEVEL!! Spacious family room with sit-up bar and master bedroom with balcony. Shopping & schools nearby. Compare to other sales and you'll know why this one will sell FAST.
The dumbest loan ever made
This property was purchased on 11/14/2004 for $590,000. The owner used a $472,000 first mortgage and a $118,000 down payment. The owner did not HELOC the property.
On 11/17/2007 — several months after the credit crunch took hold in August of 2007 — World Savings bank give this guy an Option ARM for $595,000. WTF were they thinking?
When you consider the timing and the general state of the mortgage and real estate markets when this loan was made, it makes you wonder if the borrower knowingly gamed the system to get his down payment back. I have given him a D, but a case can be made for an F.
I hope you have enjoyed this week, and thank you for reading the Irvine Housing Blog: astutely observing the Irvine home market and combating California Kool-Aid since 2006.
Have a great weekend,