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December 30, 2009

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Christine

"delayed gratification is part of being a grownup"

And part of the job of parents is to teach that difficult lesson to our kids.

Bernard Guerrero

Doug, I think you're making a mistake here, two separate ones, really, though not because of any "moral" requirement for one to pay one's debts. (I really dislike using that term.

In point of fact, debt is a major structural element of the social fabric. I tend to agree with Thatcher that there is no such thing as society, if we're using the term to mean some independent entity with its own interests. What society is, is the system of rules by which a bunch of otherwise atomized interest (you, me and the guy behind the tree) are allowed to interact. There is no _moral_ imperative to support a given design of that social fabric/operating system; I didn't design it & neither did you. There are valid practical reasons for wanting to do so, though. I'm one of them, as it so happens.

Felix is making the mistake of taking a dynamic equilibrium for a static one. "Ruthless default" is not a new concept, just one that's gotten more play than usual recently. I can assure you that ten years ago lenders were well aware that a given percentage of borrowers might default despite having, at least in theory, the means to continue servicing their debt, particularly if they found themselves in a deeply negative-equity position. I myself have put together a number of empirically-derived models that take into account LTV ratios for loans backed by collateral, which in effect increase the perceived risk of a loan for precisely that reason. The thing is, that increase in risk ultimately depends on something you can't observe directly, which is the prevailing attitude towards "walking away". So it's worked into existing pricing and rates; it was dominated during the boom, as was much else, by the simple fact that most vintages looked good because a borrower in trouble could always sell into a rising market or refi into a new vintage. Nobody was ever underwater, so it didn't matter.

But that was a historical anomaly. Under the current circumstances, the remaining lenders are starting to pay attention to it again, with only the government's policy of having FRE/FNM/FHA continue to take on questionable paper mitigating. And that's not gonna last, either. If "ruthless default" becomes a lot more common than has previously been the case, I'd suggest that LTV requirements will end up getting a lot tighter than they were even pre-bubble, and that the remaining lenders will hit "blemished" credit a lot harder than they did during the bubble. In effect, credit will contract further and pricing will become that much more onerous, with more folks at the bottom of the ladder being pushed towards "hard money" lenders not unlike my current incarnation. Good for (my) business, certainly, but I'm not sure it's what you all really want to have happen at a societal level. The risk here, pace Felix, is not a temporary ding to a given defaulter's credit. It's the chance of a fundamental shift in the calculation that underpins all credit.

Doug M.

Bernard, what's my second mistake?

As to the first one: you're basically making a Kantian Imperative type of argument: if too many people do this, Bad Stuff will happen system-side. It's a practical argument, not a moral one. Yes?

That's fine. In fact, IMO it's probably the strongest argument that can be made. (And it's a major point against McArdle that she was too stupid to come up with it. Really. You read her response post, and it's like something from Usenet, and not in a good way.)

That said, it still begs the question: is it not equally a Bad Thing if banks and other lenders behave in this atomistically self-interested way? If not, why not? If yes, then why do we accept the negative externalities from "bad" self-interested behavior on one side of the equation, but balk at it on the other?


Doug M.

Bernard Guerrero

Apologies, I think I should have said "linked to tow different errors". Waldman originally makes what I think is a "fairness" argument, saying basically that what is good for the corporate goose should be good for the consumer gander while decrying that we live in a Friedmanite world where this should be so. Felix Salmon, OTOH, also mentions in passing that it's a minor matter in practice and that you don't need to worry about the results.

As to mine being a practical rather than a moral argument, yes, entirely true. I view it from precisely the angle that I expressed about the Argentine defaults and the IMF the first time we met in person; as a practical matter, you need to do X to get a reasonable result, regardless of personal distaste.

I suppose, in a sense, that I'm making a Burkean argument, in that I see the historical "moral social fabric" that pushes one to pay off even when underwater as having a positive practical reason for existing, in that it makes borrowing a lot cheaper and easier to the extent that it exists. I don't like introducing moralism into discussions of finance (again, looking back to an IMF telling an Argentina that was having a coronary that it needed to go on a diet; possibly true and "moral", but a bad idea in the near term)

As to whether it's a Bad Thing that corporations (and governments) do this, well, I think it's just a Thing. If you lend to GM or Lehman, you do so knowing that they might blow it and, even if assets exist, you might not get a slice to cover you. If you lend to Ecuador, you do so realizing that sovereigns have and can default on you (or play games with you) with little recourse on your part. So you price it in or you take your lumps.

My argument in this case is merely that the equilibrium where a bank thinks a consumer likely or definitely will walk away when underwater is probably one that many of the consumers will not like as much as they think they might. You might, by extension, argue that lending overall would be easier and cheaper if corporations and sovereigns didn't behave in this fashion, too. That's a legitimate argument, although that gets us to imposing a new "moral" code on large institutions when we're currently seeing it start to evaporate at the level of the individual.

James Bodi

Am I missing something? As I understand it, under American mortgage laws, you default and the bank takes the house and you're quits. So those who walk away are playing by the rules. Why would anyone expect them to keep pouring money into a rathole? Certainly business don't operate that way - they take advantage of any way possible to cut their losses, and societal effects be damned. Why should it be any different from individuals?

McArdle is that stupid person that writes in the Atlantic, isn't she? Man, that magazine has declined.

Randy McDonald

Why the Atlantic dropped its fiction section I don't know.

Bernard Guerrero

James, gross simplification.

-Technically, you never give a house "back to the bank". The bank never had it. You sign a note saying you owe the bank X and you also sign a deed or mortgage offering your house as collateral securing said debt

-Technically, the bank on foreclosing merely forces you to sell the house at auction in order to collect the funds, per the lien described above. They will often bid at said auction themselves to protect their own interest, tho.

-Depending on the state and whether the mortgage is for purchase or refi, the lender may have recourse to deficiency judgments and the like. i.e. You owe 200K but the place sells for 150K. The bank can pursue a court case to collect the deficiency of 50K. Cali is a non-recourse state, so no deficiency judgments. Of interest, a listing.

-As I have noted, walking away is playing by the rules, the legal rules. Corporations are expected to default if their debt exceeds the equity value of the company; there's a whole line of credit analysis that takes debt to be a put option on the company's assets.

-Much of this discussion is predicated on the fact that consumers do not generally behave like corporations in this regard. A requirement to pay your personal debts appears, empirically, to be a part of the moral/social fabric to some degree.

-McArdle's argument has largely been to merely decry the "fraying" of the social fabric implied by consumers becoming more ruthless (i.e. more like a Merton finance textbook). This is a "moral" argument, and one that strikes me as a little silly.

-My own argument is that the consumer actually benefits to some extent from that social expectation, in that guys like me charge the rest of you less than we would otherwise because more debts get paid than one would expect if you were all Merton textbooks. If we see that going away, we'll adjust pricing accordingly.

-This also leaves aside the minor matter of what the default will do to the borrower's credit. That didn't matter so much for the last decade because there was always somebody willing to lend to you in a rising market. But, well.....

-On the upside, I will always be willing to lend to you, regardless of market or most credit history. I even like recent BKs. But you'll pay out the nose for it. :^(

James Bodi

Point taken about credit history. One of the new fears of the millennium seems to be a bad credit score: commercials about credit ratings are right up there with cialis and lipitor on American TV. (Or at least on the History Channel - their demographic seems to be impotent deadbeats oozing bad cholesterol from every pore).

I think the prospect of higher rates due to more walkaways is a bit remote to motivate many people though.

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