Regarding Foreclosure Options

Megan McArdle has been commenting on foreclosure and she has made some excellent points, like "the perils of jingle mail", which is to say that returning a house does not, in many states, remove your obligation to pay for it.


With her article"Foreclosure Options" however, she turns to the desirability and ethics of recourse (a mortgage holder can sue you for debt after foreclosing on your property) versus non-recourse mortgages, and comes down heavily on the side of recourse mortgages, particularly in a moral sense.

But another question occurred to me. "Let's turn it around," I asked. "What if the bank decided that it wanted to exercise the same sort of option?"

"What do you mean?"

"What if the bank foreclosed on your house, even though you made the payments, because it figured it could make more money taking the house and selling it?" (Not a likely scenario, I know, but a useful thought experiment.)

I could tell from his face that he didn't think this would be fair. But assuming that the bank can get away with it, why would it be wrong for them to do this? (We were discussing morality, not practicality) If you get to decide when they get the house, and when they get the payments, why is it unfair when they exercise the same option?

There is an outstanding reason that giving a mortgage borrower an "option" to cease payment, and forfeit only the security of the real estate is NOT like giving the bank the option of foreclosing to aquire increased real estate value. When a mortgage borrower stops payment, they lose not only the property, but also all the accumulated equity they have acquired. The bank does not give any money back. The value of accumulated equity lost should be sufficient to compensate banks for their loss of "options" inside a mortgage contract.

The simple morality of mortgage loans aside, there are also sound macro-economic reasons to advocate no-recourse mortgage loans. Real estate bubbles are likely to have a significant and negative effect on the economy at large, affecting even people and businesses who act responsibly. Banks are unlikely to encounter large numbers of people giving up their mortgage equity unless there is a severe devaluation in the real estate market, and a bubble is the most likely cause of this. No-recourse mortgages provide an incentive for banks to discourage, rather than encourage notable real estate bubbles and misvaluations.

This incentive is important even though it is not likely that it will eliminate large market corrections on a multi-generational timescale, like the present economic downturn.


The majority of real estate bubbles and misvaluations take place on a local scale, and will take place at any point in the overall economic cycle. At this very time, there are still a few areas of the country like portions of North Dakota where bubbles are present, or are a risk. These many little bubbles will cumulatively inflict significant economic damage on a national economy over time, unless, and to the extent that they are suppressed. Banks are inevitably better equipped to appraise real estate and evaluate value than most members of the public, and non-recourse mortgages encourage banks to convey this information, or at a minimum, act on their own pricing information to forstall real estate bubbles built on borrowed money, rather than hide this information.