Sent by Kevin Dwyer on 04-29-2010:
I fully agree with Brent T. White's response to Luigi Zingales' article. Morality has nothing to do with paying on a contract. While there may be legal issues to consider, I think it's a great idea: either do a short sale, or just walk away. The U.S. government as well as state governments put Americans at risk with no oversight on the lending side, for corrupt brokers, realtors, appraisers, and banks. Illegal immigrants making only minimum wage were qualified for $100K - $300K homes. And from what I see in Florida, the problem is getting worse. Where are the writers at City Journal to condemn all these practices?
Sent by abprosper on 04-29-2010:
Worrying about "strategic defaults" by the big lenders is just moral parasitism by the powerful. It seems its OK for lenders to act in any irresponsible self-serving way they wish and get bailed out on working people's dime, and then when those same people start to act in a rational, self-serving way, it's now somehow a breach of trust?
I don't think so. What's sauce for the goose is good for the gander. The fact is, the big boys don't have an inherent right to the status quo, and what they sow becomes what they reap. Good. Its time for the powerful to share the bed the rest of us have to lie in.
Sent by J.NormanSayles on 04-28-2010:
Escaping a landslide of debt may be the only way to survive, literally. A dear friend lost his business through a virus that wiped out his hatchery. He struggled for years to pay off his debts, but finally gave up and committed suicide. There is more than dollars and cents involved in bankruptcy and mortgage default. There is the human element in the equation, not always evident to the outside observer.
Sent by Bill Drissel on 04-27-2010:
White says, "...underwater homeowners promised to pay their mortgages when they signed mortgage contracts, and it would be immoral to break these promises. ...I disagree ..."
Sure glad I don't have to trust him!
Sent by Jim Stallings on 04-27-2010:
If homeowners stop dwelling on TV shows that have names like Flipping Houses and consider their dwelling largely an abode, they might think of their home less a cargo of tulip bulbs purchased for a handsome profit and more about its primary purpose.
If I bought Dell at $40 on 11-30-00 when the great market bubble soared upward, and then dropped to $6 on 6-1-01 when I wasn't watching, do I beg my broker for a do-over or lobby for a tax law that refunds my loss?
If they bought more house than they could afford, and then the property decreased in value because the neighborhood changed, a highway went through or airplanes fly lower overhead or more often, their job is further away, well, welcome to real TV. It is no different if the value dropped due to some other aspect also not in their control.
If they purchased more than they could afford, they gambled and lost. There are consequences for making bad decisions and for stupidity. If they agreed to an ARM, again they were stupid, and gambled and lost. I wouldn't touch an ARM to finance a residence no matter what was promised on the horizon. Signing an ARM was tantamount to shouting "I can't afford this house."
I remember the ponzi scheme in the mid 70s operated by a couple of men, Smallwood and Delay, who offered 50% return on loans made to them. They could not show any source of income. It took two years before they were caught.
In the current situation, the crooks were in Congress. But they are still crooks.
As a result of the housing collapse, many Americans have seen their homes lose half their value, owe several hundred thousand dollars more than their homes are worth, and are unlikely to dig out of their negative equity hole for decades. To compound their anxiety, theyve often discovered that their lenders wont even talk to them about loan modifications or short sales as long as they are current on their mortgages. With no help in sight, some of these underwater homeowners have decided that they would be better off letting go of their homes and have thus stopped making their mortgage payments, even when (by some measures) they can still afford to. Many of these strategic defaulters have done so in the hope that defaulting will finally bring their lenders to the table, but theyve also resigned themselves to the likelihood that theyll lose their homes.
In his recent article in City Journal, economist Luigi Zingales suggests that strategic defaults are immoral and socially irresponsible. He also criticizes me, along with Roger Lowenstein of the New York Times, for supposedly contributing to the social menace of strategic default. Before I respond, let me emphasize that the decision to default strategically on a mortgage involves many complex, localized, and individualized factors. For that reason, Ive never advised underwater homeowners as a group to default strategically on their mortgagesand I am not doing so here. No one should decide to default without sitting down first with a knowledgeable professional to discuss the best course of action. But lets say that youve done the calculations and concluded that defaulting on your mortgage is the only way out of your financial nightmare. Would it be immoral or irresponsible for you to do so?
Zingales says yes, and his argument boils down to two points. First, underwater homeowners promised to pay their mortgages when they signed mortgage contracts, and it would be immoral to break these promises. Second, if all underwater homeowners defaulted, the housing market would likely crash again. If that happened, homeowners would bear moral responsibility for contributing to the destruction of the U.S. economy. Homeowners thus have a moral obligation to pay their underwater mortgages.
I disagree on both points. A mortgage contract, like any other contract, is purely a legal document, not a sacred promise. Think of it this way: when you got your cell phone, you likely signed a contract with the carrier in which you promised to make a standard monthly paymentsay, $100for two years. Lets suppose, though, that two months after you signed, the price of cell-phone service dropped by halfmeaning that you could get the same service for $50 a month with another carrier. You realize that it would make financial sense to pay the one-time early-termination fee of $300 and switch to the $50-per-month carrier, rather than to keep paying $100 a month for almost two more years. Would it be immoral for you to break your contractual promise with your original carrier? Of course not. That option is part of the contract, as is the consequence of breacha $300 early-termination fee. There is absolutely nothing immoral about exercising this option, and youd be financially wise to do so.
Though a mortgage contract is more substantial than a cell-phone contract, its no different in principle. Like a cell-phone contract, a mortgage contract explicitly sets out the consequences of breach. In other words, the lender has contemplated in advance that the mortgagor may be unable or unwilling to continue making payments at some point and has decided in advance what fair compensation in that event would be. The lender then wrote that compensation into the contract. Specifically, the lender probably included clauses providing for foreclosing on the property and keeping any payments that have already been made. In most states, the lender may also opt to pursue a deficiency judgmenta court order that the borrower pay the difference between the funds received by the lender from a foreclosure sale and the balance remaining on a debt. By writing these penalties into the contract, the lender has agreed to accept the property, and (if state law so allows) the option to pursue a deficiency judgment, in lieu of payment. Of course, lenders dont often pursue borrowers for deficiency judgments, even in states where they can do so, because its usually not economically worthwhile.
Nevertheless, thats the agreement. No one forced the lender to signor writethat contract, and the lender wouldnt hesitate to exercise the right to take a defaulters house if it was financially advantageous to do so. Concerns of morality or social responsibility wouldnt be part of the equation. The borrower, for his part, has to be just as willing to accept the consequencesagain, foreclosure and usually the risk of a deficiency judgment.
So the law doesnt treat breach of a mortgage contract as a moral wrong. Still, shouldnt you keep your promises? Thats a fine principle as far as it goes. But the promise to pay your mortgage shouldnt be regarded as more sacred than any other promise. We break promises all the timewithout being considered immoralwhen the consequences of fulfilling them become too great. I recently promised my daughter, for example, that Id pick her up early from preschool. Though I take promises to my children seriously, I had to break this one because an important meeting ran long at work. I had competing obligations and had to make a choice. Though some might quibble with my choice, it wasnt immoral.
In short, its simplistic to suggest that its always immoral to break a promise. A more accurate description of the social norm is that one should keep ones promises unless one has a compelling enough reason not to. For example, needing to move in order to take care of a seriously ill family member would be a good reason, at least in most peoples estimation, for a renter to break a lease agreement. The landlord might pursue the renter for the remainder of the lease payments, sure, but few would think the renter immoral for taking that risk. Indeed, not only is breaking a promise frequently acceptable, sometimes its the most moral thing to do.
This principle applies equally to mortgage contracts. Homes are many Americans primary, and perhaps only, investment. With encouragement from the government and the financial industry, most Americans came to see investing in a home as the primary route to retirement security, and as a means, through accumulated equity, of sending their children to college. With the housing bust, however, these hopes have vanished for many homeowners. Moreover, because housing prices were so high during the boom, many Americans had to stretch to buy even modest homesmeaning that all or most of their disposable income goes to paying the mortgage, with little left over for savings. This might have worked out if housing prices had continued to increase or at least stayed stable. They didnt.
As a result of a largely unforeseen, unprecedentedly severe housing collapse, many underwater homeowners now find themselves pouring all or most of their disposable income into a house that is no longer a sound investment but instead a threat to their financial security. The moral course in such a case may be, in fact, to stop paying ones mortgage, even if one can afford to keep paying according to some arbitrary debt-to-income ratio established by the banking industry. It might be more responsible to give up ones home, start renting instead, and put the money saved into a retirement accountso that one does not become a financial burden to others in old ageor into a college fund, so that one can give ones children a chance at higher education. Ones promise to pay a mortgage, such as it is, should sometimes give way to more important obligations to provide for ones familyespecially when the lender specifically contemplated the possibility of default in the mortgage contract.
Zingales suggests, however, that its wrong for an underwater homeowner to make the best financial decision for his family because it might cause the economy to collapse. In other words, it is the moral responsibility of the underwater homeowner to do his part to shore up the economy, almost regardless of the personal sacrifice. Even aside from the irony of arguing that individuals in a capitalist society must make personal economic decisions for the collective good, its unfair, in my view, to ask a homeowner to prop up the housing market on his back.
But if we do follow Zingales down this collective path, why is it that only homeowners and not financial institutions are called upon to sacrifice their own economic well-being for the common good? As weve clearly seen by now, lenders modify mortgages for underwater homeowners only when its in their financial interest to do so. From the lenders perspective, modifying a mortgage for a homeowner who is still making payments on time is potentially throwing money away, because the homeowner might still make his payments even without a loan modification. This is why underwater homeowners typically have to default on their mortgages before lenders will talk to them. If lenders were less intransigent and more willing to negotiate, underwater homeowners wouldnt have to walk away from their homes in order to save themselves from financial ruin, and we wouldnt have to worry about the fragile housing markets crashing again. Why speak of morality and social responsibility only when talking about strategic default by homeowners, and not by financial institutions or large corporations?
The Mortgage Bankers Association, for example, strategically defaulted on the $70 million mortgage for its Washington, D.C. office building. Morgan Stanley did the same on a $1.5 billion mortgage on five buildings in San Francisco, despite raking in record profits last year. Neither was criticized for being immoral. Apparently, whats good for Morgan Stanley or the Mortgage Bankers Association is good for America. Only the little guy must take his lumps for the common good.
Zingales justifies this double standard by arguing that commercial mortgage contracts are somehow fundamentally different from residential mortgage contracts. He claims that parties to commercial mortgage contracts contemplate the possibility of default in advance and agree on the remedytypically, surrender of the property. He suggests that this is not the case for residential mortgages.
To the contrary: residential mortgage contracts, just like commercial mortgage contracts, contemplate the possibility of default and contain an agreed-upon remedy. The only difference is that sophisticated commercial parties frequently negotiate more favorable terms than the average homeowner does, including provisions that sometimes more strictly limit the lenders recourse in the event of default. But this is not a moral difference, and it doesnt change the fact that both types of contracts contain agreed-upon remedies in the event of default. It just cant be the case that its morally acceptable for financial institutions and large corporations to default on their mortgages, as long as theyre willing to bear the contractual penalty, but that its not acceptable for the average American to do exactly the same thing.
I would favor a world where all actors, both corporate and individual, were legally required to act in socially responsible ways. In such a world, institutional lenderswho bear a much greater share of the responsibility for the housing crisis than the average underwater homeownerwould be required to take responsibility for their actions by writing down at least part of the principal on underwater mortgages. In fact, thats why I agree with Zingales and his colleague Eric Posner that its time to force banks to write down underwater mortgages. Zingales and Posner propose that lenders be required to give underwater homeowners the option of resetting their mortgages to the current value of their houses in exchange for giving the lender 50 percent of the houses future appreciation. Enough with guilt-tripping underwater homeowners into holding on to their homes. Instead, lets focus on equitable and practical solutions to the negative-equity crisis. The Zingales/Posner proposal would be a great start.
Brent T. White is an associate professor of law at the James E. Rogers College of Law at the University of Arizona. He is the author of Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis.
I thank Professor White for his response to my article. I appreciate the way he has clarified the fundamental differences between our positions, and I am grateful for the opportunity to answer his arguments.
The first point of distinction between White and me concerns trust, reputation, and the value of a promise. I agree that its simplistic to suggest that its always immoral to break a promise. But breaking a promise whenever its in ones interest to do so undermines trust among individuals, and recent economic research has shown this trust to be one of the key ingredients of advanced societies. In his example, he argues that its legitimate to break a promise to pick up his daughter from school. But of course the reason for breaking his promise will have an influence on his reputation with his daughter. If the reason was, say, to assist a colleague who had a heart attack, Im sure that his daughter would understand. But if the reason was, for example, that he didnt want to miss a favorite TV show, his daughter might well trust him less in the future.
The same holds for people walking away from their mortgages. Banks will refuse to lend to people who have strategically defaulted, landlords will be leery of renting them apartments, and even potential employers or business partners will steer clear out of concerns about the reliability of those who dont honor their promises. This is a significant cost that homeowners with underwater mortgages have to take into consideration before they default. Ignoring these costs could lead them to make bad decisions. (I agree, by the way, that people should default in certain extreme situations. If they become sick or unemployed and cant support their children, for instance, default is both a rational and a moral course of action. But I would describe this not as strategic default but as standard default. My article deals only with people who can still afford to pay their mortgages but choose not to because its no longer in their financial interest.)
My argument went a step further. I claimed that the social stigma suffered by those who default strategically is the result not only of a purely personal calculationthat its risky to deal with people who breach promises too easilybut also of a social norm. Precisely because this behavior is so deleterious to communities and societies, it carries a negative social cost. Opinion makers and academics alike should endorse and sustain this stigma. I dont believe, as White suggests, that individuals in a capitalist society must make personal economic decisions for the collective good, but I do think that they shouldnt be oblivious to the social consequences of their actions.
Here lies the second major difference between us. White seems to suggest that there is no distinction between morality and legality. I strongly disagree. I think these are two distinct sets of norms that differ in their enforcement mechanism. When we break the law, we suffer consequences imposed by a court of law. When we break a shared moral norm, we suffer a social sanction. This sanction is imposed by the court of public opinion, where the standards of proof and the level of feasible punishment are more lenient. A contract stating that I will pay my mortgage only when I can afford it would be difficult to enforce in a court of law, for reasons that I explain in my article. Yet if this agreement is not a contract but a promise, it can be enforced in the court of public opinion: if I walk away from my obligations without a compelling reason, my neighbors and friends will shun me socially. The existence of the promise and the social enforcement to honor it makes the provision of mortgages more efficient. As an economist interested in social welfare, I believe that this moral norm is economically beneficial and that we should sustain it.
This is not true of all moral and social norms. In many African countries, people who become rich are expected to support all their relatives. This practice acts as a tax on entrepreneurship; it is harmful, from an economic point of view, and I would therefore oppose it. But sensible social norms can be useful in forcing individuals to internalize some of the likely consequences of their actions. While most economists advocate taxation and regulation to deal with these consequences, I preferwhen feasibleto rely on social norms, which draw their power from social consensus. I regard Whites dismissal of this social norm as dangerous because it undermines the consensus.
The third difference between White and me involves the idea of responsibility. He maintains that when a homeowner finds himself severely underwater, the moral course in such a case may be, in fact, to stop paying ones mortgage, even if one can afford to keep paying according to some arbitrary debt-to-income ratio established by the banking industry. He argues that many Americans had to stretch to buy even modest homes during the housing boom and that paying their mortgages threatens their savings for retirement and for their childrens college educations.
This seems to subscribe to the view that underwater homeowners are simply victims of society. Now, there have certainly been cases of predatory lending that deserve aggressive prosecution, but absent fraud, its dangerous to claim that individuals are not responsible for their actions. When a family stretches its budget and gambles both the college fund and the retirement savings to buy a bigger house, it should be held accountable for its choice. Such gambles have often paid off and made homeowners richer without anyones arguing that their gains should be shared with society at large. More recently, the gamble didnt pay off; why should we hold society responsible now? Undermining individual responsibilityprivatizing gain and socializing lossthreatens the fundamental principle of a capitalist economy, whether youre bailing out banks or homeowners.
A feasible alternative exists, however, one that helps stretched homeowners without rewarding imprudent behavior: the proposal that I have advanced with Eric Posner, which would require lenders to give underwater homeowners the option of resetting their mortgages to the current value of their houses in exchange for giving the lender 50 percent of the houses future appreciation. Im pleased that White supports it.
White deserves credit for having stated clearly what many people believe. He coherently elucidates a view of the world common among economists and lawyers: that the pursuit of short-term financial interest is the right course of action. I hope Ive convinced readers, if not White, that this position is both wrong and dangerous: wrong because it ignores the reputational costs that people suffer when they walk away, and dangerous because it undermines the moral basis of our society.
Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business and a City Journal contributing editor.