Mortgage Defaults Again

A quick follow-up on the mortgage default issue: people left some great comments on my last post. The key question, I think, is the nature of the agreement between a bank and a borrower. Luis characterizes it as follows:

The ‘deposit’ of the collateral is carefully analyzed to make sure that it matches the value of the loan, with the bank taking on not some random risk ($600, $10, whatever) but the very specific and known risk that the house is worth less than the appraiser appraised it for; in exchange for the profit of your interest payments the bank takes on the risk that (1) you’ll default and (2) if you default, the house will be worth less than they appraised it for. That is the essence of the commercial transaction which is going on, and the banks are very well prepared (and have strong commercial incentives) to appraise both the borrower and the house during the mortgage process.

I don’t actually have a strong objection to this view, although I’m not totally persuaded by it. Interestingly, this is precisely the Robert Lowenstein view Matt was objecting in his post: that defaulting on a mortgage isn’t morally objectionable because the terms of the mortgage contract allows for it. Matt advanced the alternative argument that you don’t need to pay your mortgage because one has weaker moral obligations to “publicly traded for-profit corporations” than to other kinds of entities. I think this is clearly wrong, which was the main point of my shoplifting hypothetical.

One reason I’m somewhat conflicted about this issue is that I’m a big fan of Megan McArdle’s work on America’s generous bankruptcy system. One of the key properties of a dynamic economic system is a tolerance for fast failure. People make mistakes, and I don’t love the idea that someone who takes on a mortgage he can’t afford at 25 will be financially crippled until he’s 55.

But I also agree with Megan that social pressures and law work as complements. Remove the former and you probably need more of the latter if you want access to credit. The stigma against defaults and bankruptcies is (in Megan’s phrase) part of the cultural infrastructure of a capitalist society. We shouldn’t discard it too casually.

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11 Responses to Mortgage Defaults Again

  1. Tom says:

    The stigma against defaults and bankruptcies is (in Megan’s phrase) part of the cultural infrastructure of a capitalist society. We shouldn’t discard it too casually.

    But this is why Matt’s argument is germane. Cultural norms can, in theory, help to support the operation of the financial system by promoting good behavior, which lowers enforcement costs. Put in crassly economic terms, this reduces the friction of the system and should benefit everyone.

    But a number of innovations — most if not all pursued for other reasons — have excused financial institutions from being subject to these sorts of norms. Securitization, responsibility to shareholders after a public offering, globalization, customer service automation — these and other factors work in concert to excuse lenders from the same sort of moral strictures that you’re asking borrowers to adhere to.

    Two things emerge from this. One, the lenders gain a structural advantage; to the extent that a lender/borrower interaction is a zero-sum confrontation (which, I agree, is not necessarily the best way to look at it), the borrower has lost ground and can now expect to gain less from the transaction that he otherwise might have.

    Second, once the lender has essentially excused itself from the expectations of “good behavior” that we might have of, say, a friend who loans us money, an enforcement cost externality (for whatever minimum of “good behavior” we insist upon) is now imposed on society.

    This is perhaps getting a bit convoluted. But the upshot is that I think you’re overstating Matt’s position when you read it as saying that corporations are just in it for themselves, so to hell with ‘em. What he’s saying is that we can go about things two ways: with varying and vague levels of moral obligation (“voluntary suckerism”), or with everyone pressing their advantage to the greatest extent allowable under the law. I think the former isn’t particularly sustainable in a competitive economy (and is perhaps not even desirable). The lenders seem to agree with me, and consequently it seems unreasonable to ask the naturally-at-a-disadvantage borrowers not to follow suit.

  2. Jed Harris says:

    I wrote but never actually sent an extended comment on the previous post. It’s very relevant to Timothy’s restatement of the issues.

    Bottom line: I think Timothy’s (and Megan’s) argument for more stigma is very sound. But “unilateral disarmament” by consumers is not sound. If we want to get the proposed social benefits we have to impose the same level of stigma on immoral corporations.

    Unfortunately as Robert Lowenstein repeatedly points out in the article Timothy links, so far corporations have avoided that stigma. In fact often their immoral actions are valorized as “good business”.

    So (1) I agree with the social value argument, (2) I think it is an excellent way to show we should not have an untrammeled free market and (3) the best way to trammel the market is to agree on the values we want it to respect, and enforce them through stigma” backed up by collective action.

    An insufficiently trammeled market creates strong incentives (and even legal requirements) to ignore the social effects of actions, and just act to maximize the immediate advantages. This leads to behavior that has very bad social effects as Timothy and Megan point out.

    So for example because of agressive pursuit of short term incentives, mortgage brokers made lots of bad loans. In many cases they kept the incentive payments and laid off the risk on others. They were making a lot of implicit and explicit claims and promises, including claims to borrowers that taking out this mortgage would reduce their payments, and claims to investors that this was AAA paper that was nearly as good as T Bills but with a better yield.

    These claims were misleading or false, but not criminal in most cases. The corporations had good lawyers who worked around the laws and regulations. Many individuals and some corporations got to keep their “winnings” from these practices. Note that all this behavior is intrinsic to the norm that the only valid goal of a company is to maximize profits. We have to change the norm if we’re going to change the behavior in a sustained way.

    This behavior obviously has major social costs. One social effect was a major financial crisis; we don’t yet know the cost but it will certainly be much higher than decades of unbridled shoplifting at Walmart. Another social effect was a huge misallocation of resources to housing, much more than would have been allocated in a well-functioning market. Both of these costs burden all of us, not just the guilty or unwise.

    So following Timothy, I’m suggesting we enforce a primary value on corporations: they must act to deserve public trust, or more simply they must be trustworthy. If a corporation leads its customers, employees, or partners to think things that aren’t true in ways that advantage the corporation, we should condemn it, punish it and if necessary drive it out of business.

    Note that a requirement of trustworthiness is much stricter than technical honesty. For example many CDOs really did get AAA ratings, implying that they were totally safe. If mortgage consolidators suspected that the AAA ratings they were getting were inflated, they had a moral duty (but not a legal or fiduciary duty) to tell investors not to rely on the ratings. In practice they led investors to trust the ratings, so they were “truthful” but immoral.

    Unfortunately a lot of corporations are untrustworthy and this is taken for granted and even defended. We need to demand that corporations value trustworthiness above profit, and adequately stigmatize untrustworthy corporations.

    To summarize, the value argument applies at least as strongly, and on a much larger scale, to corporations as to people who are defaulting on their mortgages. It implies that profits must be subordinate to social values, for corporations as well as for individuals. I welcome even handed endorsement of this approach, and reject calls for unilateral disarmament by consumers.

  3. Jon says:

    I’m sorry, you are just inventing this “social norm” out of whole cloth. People feel shame because it is a good thing to pay a debt and a bad thing not to have the money to pay them, but it is simply, as they say, just business.

    Reading all kinds of nonsense into contracts that isn’t there is exactly the kind of judicial activism that many people abhor. If the law says (which it does) that a mortgage and the note are contracts and are governed by certain laws, then they are. You don’t get to add a bunch of extra consideration for the bank based on “social norms.”

    You would be completely rewriting the law of contracts to impose penalties for breach that aren’t themselves part of the contract, or, *at least* specified in the law at the time the bargain is made so both parties have notice of their obligations.

  4. Jon says:

    @Jed: Amen. What do I get in exchange for this new deal? Do we get all of the kinds of leniencies and cooperation that are present in student loans? If not, no deal.

    If the banks are too stupid to correctly actualize their risk premia, they’re stupid and the market should eat them.

  5. Luis says:

    If the banks are too stupid to correctly actualize their risk premia, they’re stupid and the market should eat them.

    To be fair, it would be impossible for them to price in an unpredictable and sudden sea-change in the cultural/moral impact of default. If that had happened in a vacuum, my sympathy would be with the banks.

    But it didn’t happen in a vacumm. It was essentially impossible for consumers to price in the not-merely-amoral-but-often-actively-immoral activities of many banks during the run up of the bubble; even in the cases where the data was available to them they could not reasonably be expected to evaluate that data. So any sympathy I might be tempted to have with the banks is gone. (I think this is really Jed and Matt’s point.)

  6. Tom: I’m genuinely not sure what it is that we think the banks who lent money to people who want to walk away from performing mortgages have done wrong. I mean, obviously it was stupid to lend money to the kind of people who want to walk away from performing mortgages. But the act of walking away cannot also be the justification for walking away.

    Do we have evidence that they are abusing their mortgagors in such a way as to justify retaliation? Everyone keeps saying but “banks do this” but I can’t believe you’re saying that phone trees are a valid reason to default on money someone loaned you; I’m also not sure what globalization has to do with it. We expect banks in the US to abide by US norms and US laws, regardless of their ownership. What normative offenses have the banks in question committed in relation to their mortgagors?

    It seems that everyone agrees that walking away from a loan simply because the house was underwater would be a shitty, immoral thing to do to a friend. Presumably it would be a shitty, immoral thing to do to any individual. I’m not sure why the corporate form changes the correct action, and all the “crimes” cited in justification for it do seem to me to be along the lines of “I am entitled to spread rumors that Wal-Mart’s meat is poisoned, because I really don’t like their employment policies, or publicly traded corporations.” Even if the latter justified something, the remedy is neither well targeted to its alleged person, nor morally acceptable to most normal people.

    On a final note, people seem to be confused how long it takes to earn back the mortgage principle for a bank; depending on the interest rate, it’s more like 10-15 years than the 1-2 I saw posited in earlier threads. These banks/institutions holding RMBS are losing conservatively half their investment with each foreclosure; more if the “owner” trashes it before leaving.

  7. Pete says:

    Megan,

    Surely we’re just back to Yglesias’s point about the difference between business relationships and social relationships. So long as you’re in a business relationship, I don’t get why you need a motive for “retaliation.” If jingle mail is going to leave you better off materially, that’s the reason to do it. It’s neither illegal (like shoplifting) nor spiteful (like spreading rumours about Walmart), it’s just the smart thing for an individual to do unless they have a compelling reason not to.

    Speaking of compelling reasons, one thing that no-one’s talking about is the effect of foreclosure on one’s neighbours. That looks to me like a much stronger basis for building the argument that walking away violates an important norm. People sometimes have social relationships with their neighbours.

  8. Luis says:

    So long as you’re in a business relationship, I don’t get why you need a motive for “retaliation.”
    In fact, we’re told (when businesses take advantage of contract terms) that this is ‘just a business decision’, and it is understood that this is completely acceptable. Heck, we’re often told that a business who takes advantage of ambiguous contract terms is a good business for taking advantage of the language of the contract and what is permissible within the law.

    So real people should be held to higher standards than the corporations they are dealing with… why?

  9. Jed Harris says:

    Megan asks “what it is.. the banks.. have done wrong”?: Companies selling mortgages (banks and others) encouraged borrowers to take out loans that were bad for the borrowers. Whether or not this was criminal it was wrong, in the same sense that defaulting on an unsecured debt is wrong — it violates a norm that we need to have a good society.

    The mortgage sellers did a lot of other immoral things (creating toxic assets, ignoring their own lending guidelines, etc.) but misleading borrowers about the consequences of the mortgage terms was their primary offense against the borrowers.

    But the bigger issue is one that neither Megan nor Timothy has responded to, and that Luis emphasized. Do corporations have a duty to put moral behavior above profit? To narrow this down to a sharp point, do they have a duty to be trustworthy — to follow through on the expectations they create in their relationships?

    The argument that Timothy and Megan have endorsed clearly implies that corporations do have this duty, for the same reason individuals do — because we need these norms to have a good society. But they are not responding to this point. Perhaps they don’t want to say corporations have some higher obligation than profit. But then as Luis says, why should people be held to higher standards than the corporations? Especially when that impoverishes us, and enriches the corporations, as in this case.

  10. Jed, I don’t understand what you think I’m not responding to. As I said in the comments to my last post, I think corporations should keep their commitments too. I’m happy to say that corporations have obligations beyond profit; I’ve linked favorably to John Mackey’s argument making just that point. I think you might be attacking a straw man here.

  11. Jed Harris says:

    Thank you Timothy for your reasonable response / question. Sorry to be slow replying. The debate between Mackey and Rogers is interesting but hard to transpose directly into a position about the sort of moral obligation you and Megan are discussing, since Mackey is largely arguing for discretion on the part of entrepreneurs.

    In any case, it seems like you and I (and possibly Megan) agree on the basic principles.

    We agree that we need to consider the social costs of particular decision rules on the part of economic actors (though you don’t use those words). More specifically, the amoral pursuit of economic advantage has major negative (social) externalities through its effect on enforcement costs. (Describing the bad consequences as externalities has the advantage that they can be fed back into economic models.)

    This way of describing our situatiion seems to me obviously true and yet something that’s typically avoided by respected figures like Rogers and Friedman I don’t yet know how much we agree on the consequences of this argument; that’s a further discussion I’d like to see, but probably the comments of a rapidly aging blog post isn’t the best place for it.

    What is left for this discussion I guess is how we should put our agreement (as far as it goes) into practice. I hope we agree that concern about the negative effects of amoral economic behavior should be focused on the behavior that is generating (or has the potential to generate) the largest negative effects.

    Everyone agrees that people have moral obligations, and in the vast majority of cases people do attempt to fulfill those obligations. If most of our obligations had to be explicitly contracted and enforced social life would grind to a halt and we’d quickly regress to a very primitive level. So this is an area where at least we currently have an agreement that the basic argument applies, have social norms and pressure to keep these negative externalities down, and to a very large extent are successful. Actions like individual mortgage defaults play a very small role in the whole range of individual decisions that could be affected by amoral economic decision making, and probably even a very small role in mortgage defaults generally.

    On the other hand there is a widespread perception that corporations do not have any obligations to minimize their negative externalities. Obviously in effect that is Rogers’ argument, and I guess Friedman’s as well. (We could have an extensive side discussion about how they’d justify this, aside from simply endorsing the sort of social consequences that you and Megan anticipate.) This perception is alive and well in our current culture, for evidence just look at the repeated remarks about acceptance of amoral corporate behavior in Roger Lowenstein’s article.

    Furthermore where corporations are basically playing a prisoner’s dilemma game with their customers — as in the mortgage world — and the corporations endorse amoral economic behavior, which authorizes their defection in that game, then individuals are being (personally) irrational if they cooperate. Of course (to put our agreement in different words) as a society we need to converge on a mostly cooperative equilibrium. Any company that makes it irrational for its customers to cooperate has a negative impact much greater than the immediate cost to those customers.

    You can find many examples of corporate “defection” in the mortgage game in Design or Incompetence? The title of that post refers to the question of how deliberate these defections are, but as I’ve argued elsewhere, we shouldn’t worry about that — we should just classify the bad actors as untrustworthy. And we already agree that one of the moral values that needs to be enforced is trustworthiness. Note that one thread that runs through those examples is that corporations often simply don’t bother to fix problems that won’t increase their profits. They suffer no (immediate) penalty and don’t have to divert resources from things that do generate profits. If we are going to get moral behavior from them, they have to face short term consequences (such as intense public condemnation) at least as strong as their short term profit incentives.

    So my disagreement is not with your (or Megan’s?) principles, but with how you are pursuing them. To me it seems very clear that the biggest problems by far are coming from corporate immorality, and that’s where our efforts should be directed.

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