A few weeks ago, my friend Megan McArdle, one of the most prolific, dedicated, and insightful economics bloggers in the business, wrote a post that condemned voluntary or strategic defaults, a phenomenon in which people decide to abandon mortgages not because they’re unable to pay but rather because it looks like a bad deal. Megan maintained that this was a violation of an implicit social contract that paved the road to ruin, and a number of her interlocutors, including the very interesting Steve Randy Waldman of Interfluidity, suggested that voluntary defaults have a compelling logic.
As McArdle acknowledges (I think) with respect to revolving debt, over the past few decades the financial industry has increasingly applied the norms of hard-nosed business to its interactions with customers. Certainly, a home mortgage to an unrelated party is too high value and dangerous a transaction to be regulated by social norms alone. Lengthy contracts are necessarily involved. But that doesn’t absolve a business from its responsibility to craft financial products in a manner that conforms to interpersonal expectations of fair-play. Along a whole variety of dimensions, the financial industry has increasingly violated those expectations. Lenders drafted contracts with fees and other “revenue enhancers” that borrowers are unlikely to fully understand, and profited when borrowers managed them poorly. They enthusiastically marketed loans to individuals whom they were perfectly able to foresee could not easily bear the debt, against collateral whose valuation they knew to be dodgy, then sold those loans via circuitous paths to investors who literally could not know what they were buying. Mortgage lenders suborned appraisers to soothe both buyers and funders with overoptimistic valuations. The normative breakdown went both ways: individuals preyed on businesses too. The gentleman receiving large commissions selling unsuitable loans, perhaps prodding the borrower to overstate his income, may have been betraying his employer (or not, depending on who was ultimately going to bear the risk of the loan). Certainly the ruthless flipper was violating interpersonal norms when she took a mortgage she knew she could not afford, gambling that a huge upside if prices rose was worth a downside limited by non-recourse or bankruptcy. But she was hardly alone, and she could be forgiven for believing that those norms no longer applied at the interface between banks and customers. They did not.
My gut instincts, perhaps unsurprisingly, are with Megan. I strongly endorse her take on stigma.
We are better off living in a culture that believes that if you say you’ll do something, you’ll try your level best to do it. Most of us get pretty outraged, as we should, when companies violate those norms because hey, they’re not actually legally obligated to ensure that you have a computer that turns on, or a toaster that makes toast. That outrage serves a valuable function whether it is directed at people or companies. It allows us to put some level of trust in those around us.
Having read Roger Lowenstein on the same subject, however, I wonder, if there’s another way of looking at the issue.
And given that nearly a quarter of mortgages are underwater, and that 10 percent of mortgages are delinquent, White, of the University of Arizona, is surprised that more people haven’t walked. He thinks the desire to avoid shame is a factor, as are overblown fears of harm to credit ratings. Probably, homeowners also labor under a delusion that their homes will quickly return to value. White has argued that the government should stop perpetuating default “scare stories” and, indeed, should encourage borrowers to default when it’s in their economic interest. This would correct a prevailing imbalance: homeowners operate under a “powerful moral constraint” while lenders are busily trying to maximize profits. More important, it might get the system unstuck. If lenders feared an avalanche of strategic defaults, they would have an incentive to renegotiate loan terms. In theory, this could produce a wave of loan modifications — the very goal the Treasury has been pursuing to end the crisis.
Here’s my brief thought, at long last: As a number of economists anticipated, including Casey Mulligan, the federal government’s mortgage modification effort has been a failure. We continue to pursue an industrial policy focused on propping up the housing market, and it will lead the waste of billions more. Assuming we did see more voluntary defaults, what would be the logical response on the part of banks? My guess is that it would be tougher to get a mortgage, e.g., we’d see the return of substantial down payments. And what exactly are the downsides? We have solid evidence to believe that homeownership increases unemployment. We also know that the relaxation of mortgage requirements led to the housing bubble and the subsequent bust. It’s not obvious to me that tightening lending requirements would be a bad thing. We can try to do this through command-and-control regulation or through a decentralized market process that involves learning from mistakes, for both individuals and firms.
P.S. Regarding the link between homeownership and unemployment, Tim Harford summarized the case in Slate back in 2007.
Wherever people seem particularly keen to own their own homes—as in the United Kingdom, Spain, and some U.S. states—employment suffers as a result. English economist Andrew Oswald has shown that across European countries, and across U.S. states, high levels of home ownership are correlated with high levels of unemployment. More conventional factors such as generous welfare benefits or high levels of unionization don’t explain unemployment nearly as well as the tendency to own houses. Renting your home and staying flexible do wonders for your chances of always finding an interesting job to do.