Tuesday, December 22, 2009

Why are we even encouraging strategic defaults?

Felix Salmon has a post up, arguing about reducing the shame of default. He seems to be advocating that more people with underwater mortgages default on the mortgage, both as favour to themselves and to teach errant bankers a lesson. He says “If there’s less shame attached to default, we will end up with exactly what we want — less badly-underwritten credit, a more solvent society, and much less tail risk. We went far too many years believing without really analyzing the proposition that credit is nearly always a Good Thing.”

Well, that not only seems unhelpful but can only make things worse. What we need to be doing is shaming bankers, the ones who misled the people who shouldn’t be borrowing into taking out loans they have no hope of paying, so the bankers find a way of renegotiating these mortgages. We shouldn’t be reducing shame of default of the borrowers.

What would happen to the financial system once everyone no longer has shame of default? More defaults leading to more underwater mortgages leading to more defaults, all the way down to financial armageddon. Why stop at mortgages? What about all other indebtedness backed by any sort of asset that may have gone down in value? Stock loans? Equipment loans? People have also been known to borrow against these. And not paying debts because banks didn’t do their jobs properly could be just one step away from not paying taxes because the government isn’t spending your tax money correctly. Is that next?

Pls. let’s bring the talk back on how the mortgages can be realistically and orderly fixed. Nationalize the guilty banks, fire the errant bankers, institute the needed financial reforms. Threats like making personal defaults more common seem attractive at first, but they will only lead to more pain down the road. If defaults become at all common, it won’t be long before we forever say good-bye to any notion of providing credit to anyone.


wallstworker@gmail.com said...

I agree with you that it's not constructive to talk about encouraging personal defaults, however I would contend that given the last couple of years, there is already not that much of a "shame" cost in a personal default, the cost is really more in terms of bad credit resulting in loss of access to loans.


Greg L said...

I'm not so sure that clearing away the mortgage debt of seriously underwater people isn't the best course. As the current mortgage modification program shows, modifying seriously underwater loans doesn't work. The incentives for the lenders are to avoid curing loans that don't need it rather than trying to find the loans that need to be cured.

The cost to the economy of people who will never save enough for retirement and will under consume for the rest of their productive lives is a dead weight that must be shaken off. Otherwise the economy will under-perform for 2 or 3 decades.

We can't let the stock of debt destroy the level of economic activity for a few decades. And getting it over with quickly means letting the actors who are motivated to work it out (the debtors) clear the problem away through default.

Rogue Economist said...

Greg L, you're right, we want currently underwater debtors to be given the chance to renegotiate their loans. But my opinion is that this is something that should happen thru pressure on the guilty lenders. Encouraging mass defaults only deepens the financial crisis, and will only lead to more mortgage holders going underwater. Too much collateral damage, even on prudent lenders and borrowers. A better way would probably be to impose a restructuring along the lines of rent-to-own. There have been good discussions on this so far.