Today’s post isn’t really about bankruptcy per se, but as a bankruptcy attorney in California, as you might imagine, I have had an up front and personal perspective on the Mortgage crisis over the last several years. I was listening to the California Report on my San Francisco Bay Area NPR affiliate, KQED, last week when I heard something that struck me as so preposterous, so deceitful in its specious logic, that it stuck with me for days. The reporter, Rachael Myrow, was interviewing one Ed Gerding, the “Senior Fraud & Risk Consultant for CoreLogic,” which, according to its website, supplies “data, analytics and services” to “financial services and real estate professionals.” The piece was about mortgage fraud in California. Again, as a bankruptcy lawyer, my ears pricked up. I’ve had occasion to witness more than a few “option ARM,” “neg am” and other teaser mortgage loans in recent years as well as the inevitable foreclosures and short sales that resulted from them. And I’ve had the unique perspective of getting to know all the details of the financial lives of hundreds of homeowners stuck with these albatrosses.

I think any of us who learned anything about what led to the Great Recession will recall that the root cause was Wall Street’s invention of mortgage-backed securities, and how lenders like Countrywide, World Savings, et al., encouraged mortgage brokers (literally telling them: “Docs? We don’t want docs anymore”) across the country to peddle absurdly dubious teaser loans to unsophisticated borrowers so they could immediately package them into these exotic derivative securities and sell them to pension funds, etc. That was mortgage fraud to be sure.

But the intro to the story promised that “while you might be inclined to pin Big Blame on Big Banks, plenty of individuals are scamming the system, too.” From that little teaser, the listener was encouraged to immediately assume that we should spread the blame around equally. Individuals—you know, with all their outsized market influence, bargaining power and insight—must have been just as much to blame, right? And what is chief among Mr. Gerding’s examples of such insidious mortgage fraud supposedly so widespread that is today being perpetrated by individuals?

Short sales. That’s right, short sales.

As I said, I’m a consumer bankruptcy attorney. I work for individual debtors. I have now seen hundreds of clients who could not afford the mortgage loan they were sold in the 2000s. The one they were told at the time not to worry about because before the payment readjusted the property would have appreciated so much it would be easy to later refinance at a low fixed rate. I think I have some perspective on short sales and foreclosures in California. According to the story, a short sale is “a boon to a hard up homeowner – or someone pretending to be hard up who wants to stop paying for a house he’s underwater on.” Right there. That’s my problem. That statement is so asinine I don’t even know where to start. But I’ll take a deep breath and try.

What, pray tell exactly, is wrong, immoral, unethical or any other negative adjective implying dishonesty, with someone who wants to stop paying for a house he’s underwater on? Let’s back up here and think about some basic legal principles in contract law and economics. First of all it is a firmly established principle in contract law that where continuing to perform on a contract will lead to economic waste—like paying on a loan that grossly exceeds the value of the collateral secured by it—that to breach the contract is often the most economically efficient thing to do. Corporations quite intentionally breach contracts all the time precisely because for whatever reason—a changed economic climate, for example—it makes more economic sense for the contract to be broken than to carry on performing it. Generally, the agreement itself may contain the consequences for such a breach—by specifying liquidated damages, for example. Or, a statute may impose a different or additional penalty for breaching the contract. The point is that after calculating such economic consequences, it still makes more economic sense to breach the contract than to be enslaved to it. Conservative economists, who generally cling to the quasi-religious notion that all economic actors act with rationality all the time, cheer the idea that in capitalism, efficient use of capital often requires the breaching of contracts. The point here is that simply breaching an economic contract has nothing to do with morality.

But I digress. Back to the context of a short sale. The alternative to a short sale is a foreclosure. In California, a foreclosure is almost always carried out through a nonjudicial process, and the lender exercising their rights to foreclose under a deed of trust has no recourse beyond that process to later sue the borrower for any deficiency for any balance owed on the original note. California is, in other words, a “non-recourse” state at least with respect to first mortgages and nonjudicial foreclosures. Junior non-purchase money loans such as home equity lines are another matter, and I’ve covered these elsewhere.

Given that the alternative to a short sale is a foreclosure, which will invariably cost the lender much more than agreeing to a short sale at the current fair market value of the home, I have long felt that a short sale is nothing short of an enormous favor to the bank. Likewise, it’s a huge favor to the lender of any junior loan where they might not receive anything at all after a foreclosure. By requesting approval of a short sale, the homeowner is, in effect, finding that bank a ready, wiling and able buyer, wrapping them up in wrapping paper with a big bow on top and delivering them on a silver platter to the bank. The fact that banks will sometimes refuse to approve such a gift is beyond flabbergasting. It’s stupid. In the years between 2008-2012, I witnessed dozens of clients who had attempted to get approval of a short sale, have it refused by a hold-out lender, only later to then inevitably let the home foreclose. The foreclosure may then have taken 18 to 24 months to complete simply because the bank didn’t want the property.

While the California Report and Mr. Gerding of CoreLogic implied some widespread fraud on the part of homeowners in California trying to short sell a property they likewise implied that somehow homeowners who cannot or do not want to pay for a grossly underwater property see no negative consequences as a result of a short sale. Wrong again. Remember that to the extent that the lender does not receive the full payoff balance of the original loan, such “canceled” debt is later taxable as income to the homeowner—with just a few exceptions. For example, where the property is not the borrower’s primary residence, and unless a bankruptcy or the IRS-defined “insolvency” exception applies, the borrower will have to pay taxes on the difference between what they owed on the loan and what the bank received from the short sale. The bank gets a nice write off and the borrower may owe income taxes on debt cancellation. Hardly a windfall to the borrower. And we haven’t even touched upon the damage to the borrower’s credit that results from a short sale.

Not to be disingenuous, I am perfectly aware that Mr. Gerding, in his elaboration of what constitutes “mortgage fraud” in the context of California short sales, was talking about situations in which the homeowner is someone “pretending to be hard up” presumably in order to qualify for a lender’s capricious hardship requirements for approval of a short sale.

My point is that a homeowner’s ability to continue to pay on a mortgage that is 30% or 50% or 100% greater than the current fair market value of the property should have nothing to do with whether the bank can approve or disapprove of the short sale. A short sale should not require, and often does not require, depending on the lender, any showing of economic hardship on the part of the borrower. If there is any such “fraud” out there, then it is a fraud manufactured by the mortgage lender to the extent that it has created a barrier to a short sale that shouldn’t exist. I am certainly not advocating lying to a lender in order to get their approval. Remember, if the bank won’t approve a short sale, then the borrower can always just let them foreclose. And they don’t have to provide any proof of financial hardship for that.

The fact is now the property is worth much less than when the bank made the original loan. Either that bank or its predecessor lender they bought that loan from made a decision to lend some inflated amount that today in hindsight looks foolish. They contributed to the property value bubble in the first place in their rush to lend and then sell mortgage backed securities. Lending is a risky business. They know that. It’s not the borrower’s fault that now the house is worth far less. And it is absurd to paint homeowners as fraudsters when they make what is sometimes the most economically rational decision to let such a property go.