2. Double Standard

CHAPTER

TWO

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Double Standard

According to work done by professor White at the University of Arizona’s James E. Rogers College of Law, underwater homeowners aren’t walking away because they wish “to avoid the shame or guilt associated with foreclosure,” and “fear over the perceived consequences of foreclosure—consequences that are in actuality much less severe than most homeowners have been led to believe.”

“[T]hese emotional constraints are actively cultivated by the government, the financial industry, and other social control agents, in order to induce individual homeowners to act in ways that are against their own self interest, but which are ... argued to be socially beneficial.”

So while lenders only seek to maximize profits, borrowers are “encouraged to behave in accordance with social and moral norms requiring that individuals keep promises and honor financial obligations.”

Mortgages and notes secured by deeds of trust, are contracts. The lender provides money today in exchange for a series of payments. The money today is used to buy a house (in this case). In exchange the borrower agrees to make 360 monthly payments of a certain amount of money to retire the principle and pay interest on the amount borrowed.

That’s it. These notes don’t have caveats that if the value of the collateral falls, the borrower can (and should) give the house back to the lender, although in non-recourse states like California that is implied. Non-recourse meaning that the lender cannot pursue the borrower’s other assets if the value of the home doesn’t satisfy the note. Even in states where mortgage contracts contain recourse provisions, the cost of litigation versus the limited prospects for recovery keeps many lenders from pursuing judgments.

The borrower enters into the deal in good faith, not knowing the future of property values, his or her income, or what surprises might spring forth over the course of 30 years. The lender does the same, knowing not what interest rates will do, how the currency the note is denominated in will fare, and again what property values will be, or how well the borrower’s prospects will hold up.

However, at least one lender has no problem walking away from its loan obligation. Morgan Stanley announced at the end of 2009 that the bank planned to give back five San Francisco office buildings to its lender—just two years after buying them at the top of the market.

“This isn’t a default or foreclosure situation,” spokeswoman Alyson Barnes told Bloomberg News. “We are going to give them the properties to get out of the loan obligation.”

Morgan Stanley bought the buildings, along with five others, in San Francisco’s financial district as part of a $2.43 billion purchase from Blackstone Group in May 2007. The buildings were formerly owned by billionaire investor Sam Zell’s Equity Office Properties and acquired by Blackstone in its $39 billion buyout of the real estate firm earlier that year, Bloomberg reports. One analyst estimates that the buildings are now worth half of what Morgan Stanley paid.”

Morgan Stanley’s EBIT in 2009 was $7.57 billion, in ‘08 it was $39.81 billion and in ‘07 it was $60.7 billion. You get the idea, walking away from the five office buildings was a strategic default. There is no Morgan or Stanley losing sleep over these buildings and the encumbrances being walked away from. The shareholders of Morgan Stanley likely cheered as the company mailed the keys to the lender.

The fact is the shareholders would consider it the fiduciary responsibility of Morgan Stanley management to walk away from its underwater property loans. In an essay entitled “Natural law and the fiduciary duties of business managers,” by Joseph F. Johnston, published in the Journal of Markets & Morality, explains that the “fiduciary principle is a principle of natural law that has been incorporated into the Anglo-American legal tradition; and that this principle underlies the duties of good faith, loyalty, and care that apply to corporate directors and officers. The fiduciary duties of corporate managers run to shareholders and not to creditors, employees, and other ‘stakeholders.’ “(emphasis is Johnston’s)

The best interest of Morgan Stanley’s shareholders was clearly for the company to walk away. Their note was non-recourse. The lender has no legal right to pursue any other Morgan Stanley assets. The fiduciary duty of the company’s supervisors is the prudent management of company assets on behalf of the shareholders. Not on behalf of the company’s creditors or anyone else.

While big real estate companies are praised for making the good business decision to walk away, individual homeowners are vilified if they do the same.

Large commercial property owners believe it only makes sense to walk away when their properties are upside-down to the loan balance. As Kris Hudson and A. D. Pruitt wrote for the Wall Street Journal in August 2010, some of the titans of the commercial property business like Macerich Co., Simon Property Group Inc., and Vornado Realty Trust have defaulted on large property loans because of the fall in collateral values. “These companies all have piles of cash to make the payments. They are simply opting to default because they believe it makes good business sense,” Hudson and Pruitt write.

Vornado may be one of the nation’s largest owners of office buildings and shopping malls, but when the value of the Cannery at Del Monte Square project in San Francisco plummeted, the company defaulted on the $18 million loan on the project. Macerich gave the Valley View Center mall in Dallas to the lender rather than continuing to pay the $135 million mortgage.

Like homeowners who walk away, Robert Taubman, CEO of Taubman Centers, Inc., told the WSJ, “We don’t do this lightly,” when his company stopped making payments on its $135 million mortgage secured by the Pier Shops at Caesars in Atlantic City, N.J., after the property value fell to $52 million.

At the same time, former Treasury Secretary Henry M. Paulson Jr. declared that “any homeowner who can afford his mortgage payment but chooses to walk away from an underwater property is simply a speculator—and one who is not honoring his obligation.”

John Courson, president and C.E.O. of the Mortgage Bankers Association, told the Wall Street Journal that homeowners who default on their mortgages should think about the “message” they will send to “their family and their kids and their friends.”

“Please consider that those withdrawing money from their 401(k) to pay mortgage and tuition expenses may be the remaining righteous souls of this nation,” a reader of Agora Financial’s “5 Minute Forecast” wrote. “They signed a legally binding contract and are doing their best to uphold their end of the deal. They want their children to have a better future than they have. When those honorable and loving citizens are no longer praised for their morals and ethics and, instead, are labeled as stupid, what will be left?”

So while the Morgan Stanleys and Robert Taubmans of the world make the prudent business decision to walk away from a bad deal and doing so improves company cash flow, Secretary Paulson, Mr. Courson and other high-minded folks believe our would-be couple in Salinas—or anyone else who is under water on their mortgage—should buck up and keep paying—until they lose their job, exhaust all savings, or die: then it’s OK if they bail.