We are all Melmottes now

by John Quiggin on January 9, 2010

Hot/cold on the heels of Iceland’s quasi-default, the Roger Lowenstein in the NY Times urges underwater/negative equity homeowners to “Walk Away From Your Mortgage!”. . Lowenstein’s key point is that businesses (including those owned or controlled by the banks themselves) treat default as a straightforward business decision, to be adopted whenever it is profitable to do so. Lowenstein gives a number of examples where leading banks like (inevitably) Goldman Sachs have engaged in strategic default and urges his readers to do likewise. The piece is in a section headed “The Way We Live Now” and it’s striking that it’s taken more than 100 years for the business ethics of Augustus Melmotte to percolate through to the American middle class

To be fair, it’s only in the last thirty years or so that such ethics have become dominant in the corporate sector, to the point where a board that rejected profitable opportunities to stiff their creditors would now be regarded as having violated its fiduciary obligations to shareholders (particularly if the creditors are workers). And despite all the talk about shareholder value, a CEO who passed up opportunities for personal enrichment at the expense of shareholders would be regarded by his or her fellows as a mug.

Millions have defaulted already – (one in eight mortgages is currently in arrears). Bankruptcy is once again as common as divorce. When defaulting on debt is this common, it is hard to sustain any sort of social stigma or internalised notion that this is anything other than a financial option, like refinancing an existing loan. And, as with divorce, we must soon be reaching the point where most people who take out loans will do so in the knowledge that default is an option.

The question is – can the consumer credit system survive this? Probably it can, but the system will need some radical changes. It’s worked for several decades on the basis of creditworthiness criteria that work on the assumption that (nearly) everyone will repay their debts if they can. Until recently, the checks could also rely on the assumption that people would be more-or-less honest in the information they provided in their applications. The financial system, by promoting ‘liar loans’ colluded in the destruction of the second assumption, and by leading the way in strategic default, helped to destroy the first.

The problem for lenders now is that they will increasingly have to act on the assumption that their borrowers (including those who appear creditworthy on the old standards) are planning, at a minimum, to use default as an insurance option. The only good way to protect against this is to demand lots of secure collateral. That means less liberal credit (and, given higher default rates, higher interest rates) for everyone and no credit at all for lots of us.

{ 62 comments }

1

bob mcmanus 01.09.10 at 1:27 am

Well, in one framework it just looks to me like we are somewhere near the trough of a broadly-interpreted Minsky cycle, probably the downslope before the bottom. I would have to look at GD I or other depressions, especially those rare periods of declining real estate values, to know if this was secular. My personal experience is limited, but I do know of personal defaults during the Texas real estate crash of the early 80s.

It could, of course, be an actual permanent secular change in human nature or culture.

FDR put extraordinary effort into keeping people in their homes.

2

dilbert dogbert 01.09.10 at 1:37 am

Higher Credit Standards = Lower Home Prices
Watch out below!

3

bob mcmanus 01.09.10 at 2:05 am

Mike Shedlock posts:Consumer Credit Drops 17.5 billion, largest decrease since 1940, with some charts.

Could be a secular change, looking at the charts. But we haven’t had a long depression this bad since the 30s, so could be part of a long long cycle. When general trust & confidence is lost, you can be screwed for a generation+.

Somebody blew it.

4

Oregon Sage 01.09.10 at 2:28 am

The number of articles about mortgage walk aways continues to grow. By and large the data is anecdotal and spun with various ‘morality’ tales.

I will add my own set of data points. Growing up in a rural area where everyone knows each other’s business I learned that behavior such as loan defaults would be difficult to escape. As a young man working in the finance business during the 80’s I learned that well to do contractors fairly regularly were involved in loan defaults on real estate partnerships, however the ‘investment group’ was held responsible and not the individuals. A few years later I lived throught the S&L scandal in Arizona and helped a dozen people find new jobs before the corporate headquarters shut down our commercial loan office as the industry as a whole was weakened. Jump forward a couple more decades and I took a job in a mid sized western city at the height of the housing bubble. After looking at houses for weeks and watching every desirable, value priced property become unavailable as soon as listed we finally bit the bullet and signed on the next interesting house in a solid neighborhood. We purchased at the top of our available credit but were by no means unable to afford the payments, upkeep or related expenses. Of course that was at the top of the market and on paper we have now lost in the range of $100k. Our cash flow is more than adequate to cover the debt, but that debt service has high opportunity cost when rent would be 1/3 of the mortgage payment. At some 10-15 years from retirement age it is quite possible that we will not reach a point where the market will allow us to sell as we seek to move into empty nest quarters. In addition we are constrained from pursuing any career opportunities outside commuting distance due to the inability to sell the house. We did not create these market conditions, nor did we game the system to buy the house, but we are constrained just the same. Local law does allow us to walk away and we could likely function without the availability of other credit that might create. Meanwhile lenders want one to claim ‘hardship’, also sure to damage credit ratings, before they will consider reducing rates to reflect current levels. Walking away seems a drastic step, but in the end may be part of a required process to restore some level of sanity to personal and national balance sheets. It is time for the lenders to also feel the pain they helped create, not just a random assortment of unfortunate home owners. I have lived most of my life without home ownership and would be content to do so for the rest of my life.

There is a old term for the current situation “Throwing good money after bad”

5

Jake 01.09.10 at 2:52 am

Of course the consumer credit system can survive this. Defaulting on a loan still marks you as a poor credit risk with all the associated negative consequences. The people you see walking away are typically hundreds of thousands of dollars under water on a non-recourse secured loan; the solution is to not make loans that are likely to go hundreds of thousands of dollars underwater. This is not hard to do – get a decent appraisal and require a significant down payment.

PS: liar loans were for the bank’s benefit, not the consumer’s.

6

Ted 01.09.10 at 3:00 am

If enough people were to engage in this sort of civil disobedience, legislators would be forced to take notice and address the systemic injustices that provoked the disobedience. Ultimately, it is civil society that has to organize and take charge, whether it is defaulting on mortgages or shareholder class actions and other forms of activism.

7

bob mcmanus 01.09.10 at 3:18 am

Steve Randy Waldman has a series of posts, with great commenters, on strategic defaults.

Here’s a quote:

“I wonder what new moral lessons these men, indeed our whole generation, will now teach our children and grandchildren. I’ll guess that the content of these lessons will not include much sense of moral obligation or sympathy towards banks. Perhaps that’s for the best, moral intuitions being supportive of certain beneficial survival instincts in the modern dog-eat-dog financial world where ordinary folks need be constantly on their guard. I hope it doesn’t spillover, baby-with-the-bath-water-like, and create a generational animosity for a free market economy and open society in general.”

We have a model(s), which is close to Minsky’s (last chapter of the Keynes book is all I know), and the one that got us out of the last depression. When the economy becomes aware of the radical uncertainty and loses social cohesion, the only power that can bring it back in a socially just form is government. Massive (40-50%+ of GDP), aggressive, permanent, at least apparently, gov’t intercession. New Deal, WW II, Truman.

We may not be in that bad a shape yet, and the social conditions are not yet ripe. I think we will get there.

I suppose there can be other social equilibriums: Authoritarianism, fascism, caste systems. They aren’t as attractive to me.

And it might that the technologies of social control have developed to a point that something I can’t understand will be created. But we have a problem.

8

Satan Mayo 01.09.10 at 3:19 am

would no be regarded?

Thanks for catching this! Fixed now I hope – JQ

9

Ted 01.09.10 at 4:07 am

Thinking government is an autonomous savior is depressingly dystopian. Governments only respond to pressure from interest groups. Unless those at the bottom and middle of the pile organize and create a hullabaloo government will ignore them. Starting from a position “only the government can save us” is dangerous as it misunderstands the dynamics of government.

10

djw 01.09.10 at 5:39 am

rent would be 1/3 of the mortgage payment.

Oregon sage: you seem like a reasonbly intelligent person, so presumably you didn’t think the bubble was going to continue to inflate indefinitely. You also don’t seem like someone who was hoping to strategically ‘beat’ the bubble and sell quickly at a high profit. I ask this not out of snarkiness, but because I simply don’t get it–what was the process that lead to you conclude that buying was smarter than renting at 3X the cost (more, really, when you consider you’re now liable for all necessary repairs, broken appliances, and so on)? The “build equity” argument makes, as far as I can tell, no sense whatsoever at that price point, as you could simply invest the extra 2/3 of your mortgage (or as much of it as you wanted) yourself.

11

Oregon Sage 01.09.10 at 7:38 am

@djw

Actually declines in housing values have been very rare in the US for any extended period of time, although I did witness just such a bust when I was a much younger man. That was localized but did take over a decade to correct following the ‘malaise’ years, in Bend Oregon. Bend again had very strong growth (population grew 5X in 25 years) going into the latest decline and is again being very negatively impacted as an attractive resort and retirement location with limited industry beyond home building. But I digress; moving into an overheated market my choices were to join in and hope for the best, or stay on the sidelines and rent. Im a fairly pessimistic guy regarding the use of housing as a primary investment, contrary to many in the US, and I did expect the bubble to at least stall and possibly retract some, but the actual decline has been stronger than most would have expected. I didnt drive the prices up all by myself, and I did desire a comfortable place to live. While others were churning housing to make a strong profit I was just hoping to combine needed housing with little long term financial gain. (I’ve regularly read Krugman, Thoma and DeLong for the last several years as point of reference.)

Of course at some point ‘in the long run’ we are all dead.

My 1/3 rent comment may be misleading somewhat since it assumes rental of more modest housing than what I ‘own’. Children are gone and parents are independent so we are free to downsize. In the local market the rental rates appears to be running around 60% of mortgage payments for similar units. Of course since the tax code is subsidizing the mortgage that gap shrinks considerably after the tax deduction is factored in.

Something I havent seen anyone suggest is that ratcheting down the mortgage interest deduction could reduce the incentive to overinvest in housing in the US. This is of course opposed by powerful lobbies and is popular with the middle class, however the benefits fall primarily to those in higher income and tax brackets who can afford to carry the higher debt and then sell at a profit to boot (until recently) while living in ever more plush domiciles.

12

gyges 01.09.10 at 8:41 am

Wasn’t it Mike Shedlock who first advocated walking away, long, long before the dead tree press?

13

alex 01.09.10 at 9:35 am

Where’s the big hoo-ha in the idea of defaulting on a mortgage? Stories about people posting [mailing] their keys to the bank were rife in the big early-90s downturn in the UK.

14

Ciarán 01.09.10 at 9:39 am

If enough people were to engage in this sort of civil disobedience, legislators would be forced to take notice and address the systemic injustices that provoked the disobedience.

Alternatively, legislators would be forced to take notice and address the systematic justices that make it relatively easy for Americans to default. They’ve tried it before, even if that backfired.

Surely it’s fantasy to think of any consequence to strategic default than that the state and the banks will collaborate to make it far more expensive and difficult.

15

Tim Worstall 01.09.10 at 9:48 am

“The problem for lenders now is that they will increasingly have to act on the assumption that their borrowers (including those who appear creditworthy on the old standards) are planning, at a minimum, to use default as an insurance option. The only good way to protect against this is to demand lots of secure collateral. That means less liberal credit (and, given higher default rates, higher interest rates) for everyone and no credit at all for lots of us.”

Mebbe. My personal prediction is that we’ll see a lot of lobbying and agitation from the mortgage lenders to alter State laws on mortgages. Some States are currently recourse but most (? how many “most”?) are not. I’d expect to see a lot of effort put into getting those States which are currently non-recourse to switch.

Whether it will work or not is another matter.

Alex, jingle mail didn’t really work all that well in the UK. All mortgages in the UK are recourse. You can walk away from the house but if you’re underwater you still owe the bank/building society.

The nett effect is that it makes default on a mortgage much more costly. Instead of just a hit to the credit rating (as happens in a non-recourse jurisdiction) the only way to get out from underneath the debt is full blown bankruptcy (or variants thereof like an IVA).

16

purpleOnion 01.09.10 at 11:53 am

This problem arose when people began to follow the examples of their leaders in business and politics. If our leaders can torture with immunity, reveal the name of a covert CIA agent, conduct domestic spying without warrants, collude with each other to commit fraud, force people to surrender to legalized extortion conducted by insurance companies, start unjustifiable wars, break treaties at will, generally behave in an amoral manner with each other, and deliberately deceive each other in creative or time honored fashion than there is no leadership only examples.

17

purpleOnion 01.09.10 at 11:56 am

I have read and heard the following from several different sources:
“If one has not cheated he did not do everything he could to win.”

18

Chris Bertram 01.09.10 at 1:04 pm

A question for John Q.

Are there institutions that just can’t walk away? (I’m thinking of universities as a possibility.) And shouldn’t they therefore be granted extraordinarily favourable terms? (And if so, why do they seem all seem be be very nervous about being downgraded by the ratings agencies?)

19

Ebenezer Scrooge 01.09.10 at 1:43 pm

Jake @5 and Alex @13 are right. Consumer creditors have never trusted the moral fiber of their debtors: only their incentives. For example, the U.S. law of student loans has long been predicated on the idea that students would default on their loans if they could–and they usually could. So these loans are mostly undischargeable in bankruptcy. James Grant has written on how the long history of mortgage lending is a set of pleasant surprises to the lenders that consumers pay their debt more readily than the lenders could imagine. (All historical trends come to an end–and this one just did.)

20

roger 01.09.10 at 4:22 pm

I certainly hope that consumer advocates – that half dead group – organize to change the law to make it much, much easier to walk away from a house that is underwater. This is this depression’s equivalent of the union sit ins of the thirties. Let’s hope the pace picks up. The extension of credit, which has gone hand in hand with crushing the power of labor, has, in effect, introduced usury in the U.S. on a scale not seen since the days of the British Raj, when the Brits ‘monetized’ the village economies of India. Something had to give.
Capital’s factotums, the two American political parties, will doubtless try to jail Americans in their sinking investments, which is why the battle should be joined on the other side, with an attack on mortgages that allow the lender to attach property other than the real estate. Every state should be like California in this respect.

21

JW Mason (lemuel pitkin) 01.09.10 at 4:22 pm

I’m trying to figure out what specific claim is being made here. Is it

a) The optimal level of defaults, balancing equity and efficiency, is zero; or
b) The optimal level of defaults is greater than zero, but there is reason to believe we are already at or above the optimum; or
c) It doesn’t matter whether more defaults would make the world better by any standard; people simply have a duty to pay their creditors in full regardless of the outcome.

It also seems you believe it is impossible for changing standards for default to result in a net transfer of wealth between debtors and creditors. But why not? Why is it obviously true that the transfer to debtors in the form of increased default will be offset by less loans, leaving debtors as a group worse off? Do you also believe that it is impossible for e.g. organizing by workers to help workers as a group, since higher wages for some will just be offset by lower employment? If not, why are your intuitions so different in the two cases?

Finally, I wonder how much you’ve studied the history of sovereign defaults, and if you’ve examined the evidence (as here) that there is often no impact on later capital flows, so that the defaults simply represent a transfer for (richer) creditor nations to (poorer) debtor ones. Why couldn’t the same be true of consumer debt?

22

JW Mason (lemuel pitkin) 01.09.10 at 4:27 pm

I should add the question raised by Jake @5 (and others): why is it obvious that the constraints on lending that would result from an increasing number of defaults like these, are a bad thing? Are you arguing that the amount of real estate lending in the bubble was just right, or perhaps not great enough?

23

Tommy Krenshaw 01.09.10 at 4:36 pm

This gets me a bit fired up.

STRATEGIC default on home loans sucks. If you have the means to pay, then you should. In a real market, there are winners and losers, so we will collectively eat these decisions to walk away. Why?

I understand getting wiped out and being given opportunities to rebuild. That’s different than being upside down — those are YOUR decisions. If you entered a $750K mortgage agreement when you’re making $45K/year and didn’t understand the terms, then you deserve to be punished for your stupidity. Sorry. If you don’t understand what you’re doing, then learn.

If businesses do this as an acceptable strategy, then they deserve to perish.

Come on. This is idiotic, and I’m sick of paying for others’ poor decisions built atop a foundation of bad economic ideas. These people are NOT victims.

24

roger 01.09.10 at 5:12 pm

21 – good questions. To my mind, this is like a game of poker in which a player bets either his wristwatch or 100,000 dollars, and loses. Should he pay the 100,000 because he has an (illusory) obligation? Will his failure to do so result in him being rejected from other poker games? I think the answer to both questions is no. American history is the history of bankruptcy – from the state government defaults of the 19 th century up to personal bankruptcies today. The main group of lenders in the 19th century were British banks, who always swore that they wouldn’t lend to Americans again- and they always did, anyway.

25

Nicholas Weininger 01.09.10 at 5:25 pm

Out of perhaps tangential curiosity, why does recourse vs non-recourse always seem to be a setting mandated one way or the other by law? What are the practical obstacles to its being a choice available to borrowers with associated cost tradeoffs, like adjustable vs fixed rate?

26

Henri Vieuxtemps 01.09.10 at 5:34 pm

What does “walking away” mean exactly? If I have negative equity in my house and a large sum in my bank account, can I “walk away” and keep the money?

27

tomslee 01.09.10 at 5:40 pm

Anyone tempted to follow the advice should note that laws do differ from country to country. Here in Canada you cannot walk away, see here.

28

Jake 01.09.10 at 6:01 pm

Yes. In many states, the loan on your house is secured by the house and nothing else. You give them the deed, they tell everyone you didn’t pay your loan and are a horrible credit risk, and that’s that.

The arguments against making this optional are the standard consumer protection ones; banks have much more knowledge and power than consumers and have shown that given the chance they will maneuver people into shoddy financial products.

29

chris y 01.09.10 at 7:24 pm

Is it coincidental that a couple of minutes after opening this thread I got a spammoid pop-up offering me “my credit score”? Should I be nervous?

30

elm 01.09.10 at 7:55 pm

Oregon Sage @11

Something I havent seen anyone suggest is that ratcheting down the mortgage interest deduction could reduce the incentive to overinvest in housing in the US.

I recently heard a radio interview with a law professor who suggested doing that, here’s a link to the transcript. A bit more searching found this NY Times economics column suggesting the same. In summary, the current deduction is expensive, regressive, does little or nothing to encourage ownership, and has been capitalized by lenders and builders so it’s little more than a dubious subsidy. It’s also incredibly popular and politically dangerous to touch.

31

piglet 01.09.10 at 10:04 pm

“What does “walking away” mean exactly? If I have negative equity in my house and a large sum in my bank account, can I “walk away” and keep the money?”

I think it depends on how well you can play the system. In many cases the lender doesn’t bother to go after a defaulting borrower because they assume there’s nothing to get. I wouldn’t assume that they don’t have a legal handle, though. This needs to be clarified with a good lawyer depending on the jurisdiction.

32

annie 01.09.10 at 11:11 pm

oregon mentions that his decision to buy was made while regularly reading krugman and delong. i too was reading krugman and delong. but since i was also reading fleckenstein, ritholtz, fred hickey, jim grant, etc, i had this horrible knowledge that those reading krugman-delong had no idea–none–of the coming trainwreck.

33

Matt 01.09.10 at 11:33 pm

On “walking away”: many (perhaps most) loans made by banks and secured by collateral are “recourse” loans. That means (roughly) that if the borrower doesn’t pay, the lender can attach the collateral, but if the collateral doesn’t satisfy the amount owed, the lender can seek “recourse” against the borrower, suing her for the rest of the amount owed. So, imagine you take a loan from a bank to buy a car and the car itself is the collateral the secures the loan. But then you crash the car and decide it’s no longer worth it to you to pay the loan, since you can’t use the car- “why pay?” you think. The bank gets the damaged car, but of course now it’s not worth enough to satisfy the loan, so the bank will sue you for the rest of the money and can do all the normal things to enforce the judgment (liens, attachments, garnishment, etc.)

But, for various historical reasons, in most US states home loans(*) are “non-recourse”, so if the bank forecloses, and the sale of the house doesn’t bring enough money to pay off the loan, the bank is just out of luck- they cannot attempt to get the rest of the money to satisfy the loan from the borrower. (There are plausible reasons for this approach. Historically, and often enough now, someone whose home is being foreclosed has very little money and is usually barely staying afloat. Coming after them for the rest of the money might well force them into full-blown bankruptcy, if they are not there already, and other problems. There’s other reasoning behind it, too, but this is a big one.) So, if one has a non-recourse loan for a home, one can “walk away” and the lender is left with just the home and whatever they can get for it. (This might be even less than expected, as foreclosure sales usually don’t bring top price, for a number of reasons.) Of course, this will hurt one’s credit rating and the like, but might still be the “rational” thing to do in many cases.

(As a further point, I’ll note amusement at people in the treasury dept. and business saying that people walking away from a loan they _could_ pay are dirty “speculators”, as if those making the claims thought speculation was bad! )

(*) I’m not certain, but believe that this rule only applies to owner-occupied homes and not to commercial realestate loans and the like.

34

dave heasman 01.09.10 at 11:41 pm

Oregon Sage @11

– Something I havent seen anyone suggest is that ratcheting down the mortgage interest deduction could reduce the incentive to overinvest in housing in the US.-

This was done over a number of years in the UK by the Thatcher government. On the grounds, largely, that it was a distortion of the investment market. It appears to have had no damping effect at all on house price movements.

35

waste of trees 01.10.10 at 2:38 am

Got an email yesterday from an acquaintance that I have not seen in at least 10 years. Did the american thing, college (big debt), worked full time. Spent vacations making more money to get a little ahead. Email said “I have not been straight with you, I know I didn’t return the CDs you loaned me to start a radio show, but pride is gone. I live with 3 roommates in a one bedroom. If not for food stamps, we’d starve. We’ll be evicted on Jan 15 if we don’t pay something against the rent. I’m asking for $100.”

For my disability. this is a huge sum. I sent it a check. I am human. The american government and the oligarchs are not.

There is a blog where a husband and wife team blogged about their trip from careers in north central Texas to north central Florida. Professionals that got stranger and stranger in their emails. Writing of seeing a note taped to the mail box saying the keys are in the door, the banks got it now. Once was strange, the number they documented sounded horrifying.

Winter is coming on. Is anyone getting the supplies and space ready to keep the refugees from freezing and starving? One thing that my atheist ass knows is that the Xians are not going to do jack shit. All of those huge food dumps on every military base and all of the extra housing that the military can’t do without needs to surveyed and planned in. Won’t happen, the senior military are stealing too much to focus on the americans.

Good luck.

36

rootless-e 01.10.10 at 2:56 am

The obvious response is that all answers to such questions are found in the first part of the Communist Manifesto

“The bourgeoisie, wherever it has got the upper hand, has put an end to all feudal, patriarchal, idyllic relations. It has pitilessly torn asunder the motley feudal ties that bound man to his “natural superiors”, and has left remaining no other nexus between man and man than naked self-interest, than callous “cash payment”. It has drowned the most heavenly ecstasies of religious fervour, of chivalrous enthusiasm, of philistine sentimentalism, in the icy water of egotistical calculation. It has resolved personal worth into exchange value, and in place of the numberless indefeasible chartered freedoms, has set up that single, unconscionable freedom — Free Trade. In one word, for exploitation, veiled by religious and political illusions, it has substituted naked, shameless, direct, brutal exploitation. ”

So no more philistine sentimentalism on repaying banks. To bad. So sad.

37

Me 01.10.10 at 3:56 am

Banks oppose the best way to avoid walkaways. Allow principal cramdowns in Chapter 13.

38

someone special 01.10.10 at 6:28 pm

On element I haven’t seen discussed here is the implication of folks walking away from their mortgages on the overall economy. For me this issue is complex in the sense that at the micro level I believe that folks who can pay should pay, and maybe even people that can’t pay get saddled with debt until they have paid off what they own. On the macro level, I fear the impact on demand caused by so many folks spending so much of their money on housing. If we have folks spending 30, 40% or more on housing how will the economy be able to generate demand to put the economy on its feet?

So I am conflicted, and maybe some of you have a clearer view of how to reconcile these two divergent feelings. Here is to hoping we don’t get trapped in that 90’s Japanese stagflation.

39

Jay Conner 01.10.10 at 7:11 pm

Real estate law is stable to the point of quaintness because of constitutional protections of property rights. Once vested, the government cannot deprive you of a right without due process of law, or take property without compensation, so when you enter into a contract, you can depend on that contract being enforced in accordance with the law at the time. I believe most jurisdictions in the US allow only non-recourse liens on real property, and my recollection is that this became pretty universal during various panics and depressions in our history. Up to this point, real estate values were always adequate, and jingle-mail made no sense. The right to walk away has always been part of the deal, everyone in the loan business understands this perfectly well, and losses are factored into the cost of doing business. So, where is the moral issue ?

40

rootless-e 01.10.10 at 8:56 pm

37
That’s because, contrary to neoclassical doctrine, decisions in banks are made with an eye to benefits for the bank employee making the decision, not the firm.

41

Dr. Hilarius 01.10.10 at 11:56 pm

My parents’ generation (depression era USA) was horrified by bankruptcy, foreclosure, and debt in general. Failing to pay a loan was a sign of moral failure. That attitude has been eroding for decades but I suspect recent corporate behavior has eliminated shame as a factor in personal finance. People will play the sucker only for so long before adopting the tactics of their creditors.

I started investing in real estate (single family homes) in the late 1980s. All my experiences with banks/mortgage lenders have impressed with their general lack of competence. At one point I couldn’t get a $25K loan on a $300K rental property I owned free and clear. Because it was not owner-occupied it didn’t fit underwriting standards. A few years later the bank was willing to loan me 125% of the home’s value! Which I didn’t do because it made so sense for me.

A note on “no recourse” loans. These are historic fallout from people losing their homes in the Great Depression, a backlash against banks. But only original purchase money loans are non-recourse. If you refinance or take out a home equity loan this changes the situation. Even when banks can pursue deficiency judgments they often choose not to do so. In my state, Washington, banks can do a fast foreclosure via a “non-judicial” process or opt for a lengthy civil suit in Superior Court. The latter process will sometimes allow for a deficiency judgment but it could take years of litigation.

The flip side of walking away from a home is to put all your assets into a home in a state, like Florida, which has an unlimited homestead exemption. Creditors can take everything but your home, no matter how expensive. That’s why O.J. bought an expensive home in Florida. It can’t be touched by his creditors.

Isn’t real estate fun?

42

Omega Centauri 01.11.10 at 1:45 am

I’m living in a burb that could be considered roughly ground zero of the mortgage crisis, prices are just under 50% of peak. It is interesting that someone stuck a note on my door last night, soliciting underwater homeowners that they can provide help. So clearly we have third parties who are in the business of promoting some sort of default (or renegotiation to a lower balance). In fact even banks are promting the idea for people who can prove they are “distressed”. So just like the loan bubble was not a purely demand driven thing (refi’s and HELOCs etc. were very activly promoted), we are starting to see the beginnings of something similar on the other end.

43

Jamey 01.11.10 at 2:24 am

Ted and Ciaran, that’s a good point about this being civil disobedience. That’s both right on and slightly off. It’s slightly off, because there is an element of self interest (unless you want to classify acts of conscience as being a higher form of self interest with an emotional payoff) involved in strategic default that is not involved in acts of civil disobedience. It is right on in that civil disobedience involves the deliberate breaking of a law and a willingness to accept the penalties that come with that because you view the upholding of some principle or combatting some larger injustice as requiring it.

For more interesting discussion on this, refer to Bob McManus’s link to Steve Randy Waldman. He’s had an ongoing discussion with Megan Mcardle about the ethics of this. Waldman notes that business have for a long time adopted the rule of “We are only obliged to obey the law and live up to our contracts “(in accordance with Milton Friedmans’ view about corporations having no “social” responsibilities).

What I find interesting about this debate is the question of motive and attitude by the defaultor. It reminds me of the experiment where a day care center instituted a fine for picking up your kids late from day care. What they found was that paradoxically, this actually increased the frequency of the undesired behavior. Prior to the institution of the fine, parents actually felt a sense of moral obligation to abide by the terms of the deal and pick their children up on time. After the institution of the fine, parents’ began to look at the fine as a fee and picking up your child late as another service that one can purchase by paying the fee. It’s a basic difference between viewing things from a moral/social responsibility framework and viewing something through a market framework. Notice that the term fine itself carries ovetones of legal and moral responsibility while the term fee does not.

In the case of strategic default, one is not viewing it through the lens of “One must try as hard as possible to live up to one’s promises, even if it would be more convenient to simply renege and then accept whatever contractual consequences follow”. From the market/business ethic way of thinking, the hit to your credit record and the loss of the house are simply the “fee” that you pay from getting out of an undesirable economic situation where you are paying a good deal more for a house than it is worth.

Note: my info on the day care experiment comes from an interview and excerpt with Dan Ariely “Predictably Irrational”.

Also, I found the reference to divorce in the original post quite relevant. A few years back I was shocked to hear the term “starter marriage”. People of liberal inclinations recognize that there are all kinds of reasons why divorce may be both necessary and better than maintaining the marriage. But the conventional attitude is that both parties go into the marriage with the expectation and hope that it is permanent. Not go into with the expectation that the out clause will be exercised if convenient and all appropriate legal penalties are paid.

Personally, I would be less inclined to endorse the idea of strategic default if not for the fact that banks and other businesses have for quite a long time maintained that they have no social obligations other than to obey the law. It seems rather hypocritical for bankers and their apologists to make the argument that creditors have moral obligations above and beyond what is spelled out in the contract.

I can go on forever about this and I’m assuming that other people have, in this context and in others. I think this essentially highlights a problem with an ideology of captialism that views people as isolated individuals with no connection or responsibilities other than that mandated by law. Societies are Humpty Dumptys. Once you break them apart, it’s very hard to put them back together again.

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Bryn Davies 01.11.10 at 5:55 pm

It might be worth making the point that Melmotte not only went bankrupt – he also committed suicide.

45

mpowell 01.11.10 at 6:05 pm

Is this behavior historically unusual for underwater home owners? Let’s see the evidence that people in the same situation are actually behaving differently instead of just more people being in that situation doing what they have always done before we declare this to be a moral crisis.

46

rosmar 01.11.10 at 7:37 pm

“My parents’ generation (depression era USA) was horrified by bankruptcy, foreclosure, and debt in general. Failing to pay a loan was a sign of moral failure. That attitude has been eroding for decades but I suspect recent corporate behavior has eliminated shame as a factor in personal finance. People will play the sucker only for so long before adopting the tactics of their creditors.”

I’m curious about the evidence that this was more true then than now. Wasn’t there a lot of agitation against the banks during the Depression? And before then, too, during earlier panics? Wasn’t there often (though I’m sure not always) a sense that the bank was immoral in kicking someone out of their home/farm?

On a more personal note, several years ago my dad had a series of heart attacks while he was making $7/hour and had no health insurance. In the end he got a bill from the hospital for $780,000. Not long after, my parents’ house burned down. Fortunately, it was insured, for about $185,000. My mom, feeling a moral duty to pay her debts, sent almost all the insurance money to the hospital. The result: they had to file for bankruptcy anyway, and my mom and siblings had to live in a really horrible (buckling floors, moldy, and tiny) trailer for years.

47

Henri Vieuxtemps 01.11.10 at 7:57 pm

Maybe it’s the difference between a more …eh… palpable? entity, like the local hospital, or neighborhood bank (where, I imagine, you would borrow in the 1930s) – and a highly abstract entity that holds your mortgage these days. I don’t think the guilt of not paying to some GMAC thing can be too terrible.

48

Jamey 01.12.10 at 3:46 am

Henri, I think that has to do with the dividing line in thinking I was talking about. If the debtor feels like they have some sort of real personal relationship with the creditor, they are more likely to see the issue in moral terms. While if the debt is owed to some megacorporation, it’s more likely to be viewed simply as an economic calculation.

Feeling some sort of moral obligation to an entity or an institution is less likely than it is towards a person anyway. And it becomes even more unlikely if that institution or entity is viewed as engaging in predatory or anti-social behavior.

Hey, I’m almost expecting Megan Mcardle to suggest at some point that it’s not about the money. That the banks feel let down and deceived. It’s the betrayal of trust that stings the most.

49

Tim Worstall 01.12.10 at 12:27 pm

41: yes, I’d forgotten that. Only the first mortgage is non-recourse in almost all places. HELOCS, second mortgages and the like are recourse.

50

Barry 01.12.10 at 1:09 pm

“Hey, I’m almost expecting Megan Mcardle to suggest at some point that it’s not about the money. That the banks feel let down and deceived. It’s the betrayal of trust that stings the most.”

I’m sure that she does feel let down when people stop letting the fangs sink into their necks the glories of commerce.

51

Tim Wilkinson 01.12.10 at 2:35 pm

Jamey @48 Feeling some sort of moral obligation to an entity or an institution is less likely than it is towards a person anyway

Unless you are a judge interpreting the ‘written’ US constititution

52

SamChevre 01.12.10 at 3:56 pm

I end up on the fringe on this one. I’d prefer an explicit rule that secured loans can be completely discharged by turning over the property securing the loan. Yes, it would reduce the availability of low-equity loans. I think that’s a feature, not a bug.

53

Matt 01.12.10 at 4:08 pm

I’d prefer an explicit rule that secured loans can be completely discharged by turning over the property securing the loan.

In most parts of the US that’s actually the rule for purchase-money owner-occupied homes. (It’s certainly not clear that it should be the rule for anything else, regardless of whether we think it’s the right rule for these loans.) That’s what it means to say the loan is non-recourse. If you also mean that people’s credit rating shouldn’t take a hit for turning over the house even though it won’t satisfy the amount of the loan, I think there’s a less strong argument for that but would be willing and interested to hear the argument (especially as credit scores and the like are just commercial ratings of how eager people ought to be to lend you money.)

54

JW Mason (lemuel pitkin) 01.12.10 at 4:17 pm

Yes, it would reduce the availability of low-equity loans. I think that’s a feature, not a bug.

I agree, and remain curious why John Q. doesn’t.

55

Bloix 01.12.10 at 5:24 pm

On the moral obligation to honor contracts: you should be aware that since the 19th century it has been the explicit position in American law that the remedy for breach of contract is to make the injured party whole. There is no punitive or exemplary element to damages awarded for breach of contract. As expressed in modern economic terms, the law allows parties to do the rational economic thing: if breaching the contract and suffering the consequences is less burdensome than honoring the contract, the law exacts no punishment for doing so. Judge Richard Posner, among others, argues that failure to breach a contract in such circumstances is inefficient and thus bad for society, and therefore breaching the contract is the right thing to do. This known as “efficient breach” and there’s a good discussion of it here:
http://en.wikipedia.org/wiki/Efficient_breach

56

Tim Wilkinson 01.12.10 at 7:45 pm

Not only that but you can’t even enforce penalty clauses – i.e. default provisions specifying excessive liquidated damages – the original reason being that these deter (efficient) breach.

57

Dr. Hilarius 01.12.10 at 8:39 pm

Bloix is correct that “efficient breach” has been supported as rational economic policy. My law school contracts professor Wallace Loh (now moved on to bigger things) was a proponent of this position. But 20 years in the salt mines of law has convinced me the theory lacks reality. Breaching parties do not care about making the other side whole. They try to breach and avoid the contract consequences altogether. If the injured party has comparable resources the two can battle it out in court (itself a very inefficient process). But if there is a great disparity of resources between the breaching party and the injured party, the injured party has little hope of compensation.

In the housing arena, an example of this problem is where banks take over condos in foreclosure and refuse to pay HOA dues. This can devastate small owner’s associations. But a civil suit against BOA or Wells Fargo would bankrupt most associations long before even completing the discovery process. The prevailing party can get attorney fees and costs but only if the party can afford to get a final judgment. In most cases, the “efficient” outcome is the injured party recognizing that they can’t afford to be made whole, accepting the loss, and walking away. This may be “efficient” in some calculations but only if you ignore the cost to the idea of equal justice under the law.

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JW Mason (lemuel pitkin) 01.13.10 at 2:35 am

if there is a great disparity of resources between the breaching party and the injured party, the injured party has little hope of compensation.

But in the cases we are talking about here, the disparity in resources runs overwhelmingly the other way.

59

Zamfir 01.13.10 at 9:46 am

But in the cases we are talking about here, the disparity in resources runs overwhelmingly the other way.
Is this actually true? The whole point of the securization business was that the owners of the loan are now institutional investors, like pension funds. They have little knowledge of the actual details of the mortgages or even mortgaging as a business, and every mortgage is split over several tranches with different owners.

Under such cicumstances, it’s not that clear that the owners of the loan have a serious advantage when it comes to a court case. They might have in a few publicity cases meant to set an example, but if many people walk away, the mere cost of organizing a court case is probably higher than the potential benefit they can get from it.

60

Barry 01.13.10 at 1:21 pm

Dr. Hilarious: “This may be “efficient” in some calculations but only if you ignore the cost to the idea of equal justice under the law.”

As I’ve said before, my first reaction on hearing the term ‘efficient breach’ was that it’d end up being that McMegaCorp’s screwing over of Schmuck would be considered efficient.

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Dr. Hilarius 01.13.10 at 6:55 pm

I should clarify my remarks at 57. I was discussing “efficient breach” in general rather than specifically in regard to home owners walking out on mortgages. In the latter, the owner usually has so few assets that litigation isn’t worthwhile to a bank or institutional investor. Being “judgment proof” is protection against some litigation but not the most desirable (sort of like jail being an alternative to homelessness).

No matter how divided the interests in securitized mortgages, the interests of the mortgage holder are represented by banks or investment groups with armies of lawyers on staff. Securitization has created some interesting issues on who is the proper party to foreclose on a property. A couple of canny public interest lawyers have at least delayed some foreclosures by arguing that the plaintiffs had only a secured interest in the subject property but that only the actual holder of the original note could sue to foreclose. In some cases the plaintiffs could not locate the note or identify who actually held it post securitization. Most homeowners facing foreclosure, however, lack any legal representation.

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Jon H 01.14.10 at 2:34 am

“So clearly we have third parties who are in the business of promoting some sort of default (or renegotiation to a lower balance).”

They might also be scammers who will take your money and get you in an even worse situation.

In fact, I’d bet on that being the case here.

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