Strategic Default or Efficient Breach?

I suppose it’s Fannie Mae’s right to deny new mortgages to so-called “strategic defaulters,” as it announced this week.  But I must admit as a lawyer that the moral tinge of the discussion about borrowers walking away from their underwater mortgages has left me scratching my head.

The prevailing “economic theory of contract” that we all learned in law school teaches that when a party to a contract is better off breaching (and paying any damages owing on that account), it ought to do so.  The breach in this case is said to be economically efficient, inasmuch as the breaching party is clearly better off, and the non-breaching party is no worse off relative to whatever it bargained for.  Such an “efficient breach” is welfare maximizing as between the parties, because the sum of their total welfare is greater than if the breaching party had performed.

Now in the case of a borrower defaulting on a non-recourse home loan (i.e., one in which the lender has no right to pursue the borrower’s personal assets if the value of the home is insufficient to satisfy the outstanding balance of the mortgage), you might say that the lender is clearly worse off receiving the home when the borrower defaults than receiving the stream of payments if the borrower had not.  But the risk that the lender would be left with the home instead of the stream of payments if the borrower defaulted, for any reason, is one that is allocated to the lender under such a contract, and is presumably reflected in the price (i.e., the interest rate and other costs) that the lender charged for the loan.  The lender loses nothing when it gets exactly what it bargained to receive in relation to a risk that it was paid to voluntarily assume.

Obviously, there are complications to this idealized picture in the real world.  Large scale defaults threaten broad negative consequences for housing markets and the financial system, and these effects are magnified by the leveraging of underlying mortgages in the securitization and derivatives markets that grew up around the housing bubble.  But it is unclear to me why borrowers should bear any special moral burden to carry the cost of these sorts of systemic externalities.  And it seems ironic to me that entities like Fannie Mae, which are as responsible as any for creating the systemic risks that the default wave poses to the larger economy, are often as not the ones pushing the “strategic default” moral narrative.

After all, a deal’s a deal.

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