A response to Luigi Zingales’s “The Menace of Strategic Default”—and a response to the response
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, they’ve often discovered that their lenders won’t 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 they’ve also resigned themselves to the likelihood that they’ll 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, I’ve never advised underwater homeowners as a group to default strategically on their mortgages—and 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 let’s say that you’ve 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 payment—say, $100—for two years. Let’s suppose, though, that two months after you signed, the price of cell-phone service dropped by half—meaning 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 breach—a $300 early-termination fee. There is absolutely nothing immoral about exercising this option, and you’d be financially wise to do so.
Though a mortgage contract is more substantial than a cell-phone contract, it’s 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 judgment—a 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 don’t often pursue borrowers for deficiency judgments, even in states where they can do so, because it’s usually not economically worthwhile.
Nevertheless, that’s the agreement. No one forced the lender to sign—or write—that contract, and the lender wouldn’t hesitate to exercise the right to take a defaulter’s house if it was financially advantageous to do so. Concerns of morality or social responsibility wouldn’t be part of the equation. The borrower, for his part, has to be just as willing to accept the consequences—again, foreclosure and usually the risk of a deficiency judgment.
So the law doesn’t treat breach of a mortgage contract as a moral wrong. Still, shouldn’t you keep your promises? That’s a fine principle as far as it goes. But the promise to pay your mortgage shouldn’t be regarded as more sacred than any other promise. We break promises all the time—without being considered immoral—when the consequences of fulfilling them become too great. I recently promised my daughter, for example, that I’d 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 wasn’t immoral.
In short, it’s simplistic to suggest that it’s always immoral to break a promise. A more accurate description of the social norm is that one should keep one’s 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 people’s 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 it’s 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 homes—meaning 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 didn’t.
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 one’s 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 one’s home, start renting instead, and put the money saved into a retirement account—so that one does not become a financial burden to others in old age—or into a college fund, so that one can give one’s children a chance at higher education. One’s “promise” to pay a mortgage, such as it is, should sometimes give way to more important obligations to provide for one’s family—especially when the lender specifically contemplated the possibility of default in the mortgage contract.
Zingales suggests, however, that it’s 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, it’s 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 we’ve clearly seen by now, lenders modify mortgages for underwater homeowners only when it’s in their financial interest to do so. From the lender’s 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 wouldn’t have to walk away from their homes in order to save themselves from financial ruin, and we wouldn’t have to worry about the fragile housing market’s 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, what’s 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 remedy—typically, 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 lender’s recourse in the event of default. But this is not a moral difference, and it doesn’t change the fact that both types of contracts contain agreed-upon remedies in the event of default. It just can’t be the case that it’s morally acceptable for financial institutions and large corporations to default on their mortgages, as long as they’re willing to bear the contractual penalty, but that it’s 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 lenders—who bear a much greater share of the responsibility for the housing crisis than the average underwater homeowner—would be required to take responsibility for their actions by writing down at least part of the principal on underwater mortgages. In fact, that’s why I agree with Zingales and his colleague Eric Posner that it’s 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 house’s future appreciation. Enough with guilt-tripping underwater homeowners into holding on to their homes. Instead, let’s 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 “it’s simplistic to suggest that it’s always immoral to break a promise.” But breaking a promise whenever it’s in one’s 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 it’s 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, I’m sure that his daughter would understand. But if the reason was, for example, that he didn’t 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 don’t 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 can’t 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 it’s 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 calculation—that it’s risky to deal with people who breach promises too easily—but 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 don’t 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 shouldn’t 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 prefer—when feasible—to rely on social norms, which draw their power from social consensus. I regard White’s 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 one’s 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 children’s 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, it’s 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 anyone’s arguing that their gains should be shared with society at large. More recently, the gamble didn’t pay off; why should we hold society responsible now? Undermining individual responsibility—privatizing gain and socializing loss—threatens the fundamental principle of a capitalist economy, whether you’re 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 house’s future appreciation. I’m 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 I’ve 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.