Go Default, Young Man...

I'm glad there are some young women in the econ/finance blogosphere, and although I don't always agree with her Ryndianlibertarigaltism, Megan McArdle at the Atlantic generally relies on at some reasonable semblence of logic when she makes her arguments.  But this week, her tirade on why people shouldn't default is just more finger wagging from the moral majority, who rail endlessly against Joe six-pack (finally) making financially astute decisions while at the same time applauding corporations for doing the same (and, incidently, arguing that government has no role in preventing corporations from applying such rational financial decision making).

From McArdle:

...when I read about people like this, my outrage rises so hot:

Ms. Richey, the teacher, arrived in Palmdale in 1999. In 2004, she and her husband, Timothy, bought a two-story home on Caspian Drive, near Avenue O-8, with a no-down-payment loan.

But the value of the house plunged to less than $200,000 in 2009. Their $430,000 mortgage, with its $3,700 monthly payment, began to look more like an unwanted burden. By May, amid troubles getting tenants for two rental properties she also owned, Ms. Richey decided the time had come to cut a deal with America's Servicing Co., a unit of Wells Fargo & Co. servicing the mortgage on the house.

After three months of wrangling, she says she finally received a modification approval. The new monthly payment: about $3,300, far more than she had hoped. A Wells Fargo spokesman confirmed the bank offered Ms. Richey a modification under the Obama administration's Making Home Affordable program, and said, "The Richeys turned down the lowest payment we could offer."

Ms. Richey and her husband had already been working on Plan B -- exploring the neighborhood's "For Rent" signs.

. . .
Ms. Richey and her family made the move to Club Rancho Drive in August, when she was already several months behind on the mortgage. With Mr. Robbins's help, she recently sold the house on Caspian Drive for $195,000, money that the bank will accept to settle the $430,000 mortgage debt. She's also considering walking away from the mortgages on her two rental properties.

Showing a visitor the personal touches in her new home, including a $1,800 dining set she bought with some of her newly available income, she notes the advantages of being a renter rather than an owner.

Maybe the reporter made them sound worse than they are . . . but it sure sounds like they just decided that once the price of their property fell, they shouldn't have to pay back the money they'd borrowed.

There is a sizable school of thought that says why shouldn't they?  They made a contract with the bank under known rules, and as long as they're willing to pay the penalties, why shouldn't they just walk away, the way a corporation would?  Well, for one thing, companies don't always behave like this, and those who get a reputation for stiffing their suppliers run into trouble.  But for another, because society doesn't really work on such clean logic.  The reason we can have easy bankruptcy and a pretty robust credit market (usually) is that most people act like debts are obligations which should always be paid off if possible.  I'm not saying you should live on Kraft dinner and water for twenty years to slave at an impossible mountain of debt.  But I think before you walk away from three different mortgages, you should explore life options that do not include $1,800 worth of new furniture.

I have to agree, that the family featured in the WSJ appears to be on the more morally questionally side of the spectrum.  I doubt that the majority of individuals who default on mortgages turn around and purchase a $1800 dining room set, a little detail included, without question, to touch off some righteous indignation.

And McArdle simply isn't correct that society cannot function with such clean logic.  Contract 101 - parties will make rational decisions.  Rational.  Not ones bound by convention, morals or whatever other voodoo you want to throw at it.  And thus it must be, if we are to have a society as diverse as ours function without everyone throwing everyone else under the train tracks. 

The whole point of contracts, and the reason there are so many (oh, so ridiculously many) over-paid lawyers toiling away at negotiating the multitude of contracts that exist, is to understand all the scenarios that may arise for the other side that might prevent them from fulfilling their side of the bargain, and then putting in the penalties for non-performance.  And yes, sometimes the penalties cannot make up for the cost to the performing party.  Usually, this happens when there is something more emotional at stake than money - for example, a performer or a caterer not showing up at a kid's birthday party or a wedding.  But in strictly financial transactions, the penalty is only insufficient because the harmed party either (1) didn't do adequate due diligence or (2) was a poor negotiator.

There are some measures in our law that try to protect agains uneven bargaining power: that's the situation that most of us are in daily.  When I, Josie six-pack, negotiate a loan with a big bank, I do not have the $1000/hour lawyer available to me to make sure that I am sufficiently protected should the bank choose to do something outside the limits of our contract.  But there are laws that prevent banks from doing so, because the law recognizes the uneven nature of the transaction.  And beyond the laws, there is competition, that allows a savvier Josie six-pack to shop her business aroun to a bank with better terms, or a better reputation.

Why isn't there anything that protects the banks then?  Because they theoretically have thousands of minions that have the training to protect against these forfeitures happening.  Why, why should a bank have given a $400,000+ mortgage to a teacher and a fireman who apparently had several other real estate liabilities on their balance sheet?  WTF was the bank thinking?  I barely have the facts and I can see that this was an extraordinarily risky "investment".

But keep these things in mind: pre-recession, banks were residing in wonderland.  They were being richly... RICHLY... rewarded, effectively for making absurd loans left and right.  They lent to high-risk borrowers, with little recourse and even less dilligence, not because they were banking on their borrowers doing the "right thing", not even necessarily because they thought they would get their money back in the long run (let's face it, if the bankers truly believed in the sanctity of the promise, the CDS market would hardly have been as bubbly as it was), but because making such loans was so extraordinarily profitable in the short term.  The McArdles of the world seem to forget just how much cold, hard cash these risky borrowers was worth to the bankers that lent to them.

So don't cry boo-hoo to me now that the borrowers are doing what makes financial sense for them.  They will be penalized to the extent they agreed to be penalized under the terms of the contract.  Had the contracts been recourse, they would have personal liability.  They will take a hit on their credit ratings, affecting their "reputation" and making it more difficult for them to get their next "wad" of money.

And that's as it should be.

Update: here is another (better) article in the WSJ about strategic default.

Comments

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