• 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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    • Agreed. Additionally, if significant numbers of people do start to walk away, it should drive the holders of mortgages to find a way to negotiate lower home values. Traditionally, that has been cheaper for banks than foreclosing.

      Steve

      • Steve writes:

        “If significant numbers of people do start to walk away, it should drive the holders of mortgages to find a way to negotiate lower home values. Traditionally, that has been cheaper for banks than foreclosing.”

        Banks agreeing to a principal write-down would be far better for all parties. But, in the absence of an external market force driving the banks to renegotiate, they are disinclined.

        There is a large body of research that shows why banks don’t renegotiate.[1] Banks’ best economic strategy is to simply let defaulting borrowers twist.

        Traditionally, less than 5% of borrowers will ever default, and even now, default rates have not hit 25%.[2] So, better than 75% will pay even on irrational debt obligations if you let them.

        Historically, 55% of all defaulting loans will cure. So, banks understandably believe 55c of every dollar of modification is wasted. To make it worse, the redefault rate of modified loans is between 38% and 60% 90 days after modification (see Figure 2 of “Loan Modification and Redefault Risk”[3]). This means at best 62% of the 45% (27.9%), so 70c of every dollar is actually wasted in the bank’s mind trying to save the bottom 8% of their portfolio.

        Banks are *very* demotivated to renegotiate existing loans.

        We at HomeLiberty believe that banks will only negotiate in good faith if and when banks are forced to by the market.

        Mark Moore, CEO
        HomeLiberty, Inc.
        http://www.home-liberty.com

        [1] http://www.bos.frb.org/economic/ppdp/2009/ppdp0904.pdf
        [2] http://www.nytimes.com/2010/07/09/business/economy/09rich.html?hp=&adxnnl=1&adxnnlx=1306497856-9LVH8s/SRNWsXBjBCUWx8g
        [3]

    • I appreciate the legal view of the situation, I found it enlightening.

      With that said, I also do think there is a moral component to a contract, not merely legal and economic ones. You have made an agreement, and I think you are morally bound to *attempt* to follow through with it.

      Now, if you make an honest effort and fail, then I do not think you should be blamed (what constitutes an honest effort is somewhat case specific). But to deliberately break your word without the voluntary consent of the other party seems to me to be dishonest. Strategic defaulters are doing just that, as opposed to those who are foreclosed upon involuntarily.

    • It’s called a “promissory note” for a reason. Because in the note, you specifically “promise to pay.”

      If you are able to pay and you do not, you have broken your promise — a promise that was in writing, and a promise that was made in exchange for something of value, the loan.

      If we’re going to start letting people off the hook from their written promises (that is, contracts) simply because one side just doesn’t like the terms any more, we may as well just fold up our capitalist tents and go home now.

      • So all you educated law professionals out there explain to me why it’s ok for a bank such as Morgan Stanley to walk away from toxic mortgages to the tune of 5 billion dollars – and thats good business practice but for me- walking away from a house that was bought for $285,000 and is now worth $ 150,000- it’s not ok because I made a promise to pay. Didn’t Morgan Stanley also make a promise???