Strategic Default

One of my co-workers is contemplating a strategic default. He bought his house at the 2006 market peak at >$400,000 and it is currently worth $200,000. My guess at his household income is around $120,000. He says that they can pay the mortgage payments, but the question that comes to his mind is--why do it? They have lost >$200,000, a staggering amount even for someone with their income. Arizona has very lax rules on going after delinquents. So he's thinking about simply "walking away", i.e., stopping his mortgage payments, packing up, and moving his family into an apartment. He'll take the hit to his credit.

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it is not without risk

depending on the laws of the state, they may be looking at responsibility for the difference. Strategic default relies on how the contract was written. The house may not, and in several states, is not, the sole asset at risk. Best to consult an attorney for your state before contemplating such an action.

Strategic Bank Robbery

Ask him if he would take up strategic bank robbery if he could get away with it?

Because that is exactly what he is contemplating.

Running away from debt is not

Running away from debt is not robbery. Reductio ad incommodum fail.

Pardon me if I do not shed a tear for the bank.

Running away from debt is not

Running away from debt is not robbery. Reductio ad incommodum fail.

Pardon me if I do not shed a tear for the bank.

What about running away from signed contracts?

First of all, is this really

First of all, is this really running away from a signed contract? After all, if the contract states what will happen in case of non-payment (presumably that would be the lender taking possession of the collateral), then isn't this, rather, moving to a different section of the contract?

Second, while running away from a contract is bad, it's not bad in the same way as robbery. One typical difference is that in the case of robbery, you didn't get to choose the other guy. If you're signing contracts with people, you have the opportunity to carefully select the person you do business with. If the other person turns out to be untrustworthy, to a large extent this is a consequence of your own failure to detect his untrustworthyness. If you go broke as a result, then the market has selected against businesspeople who are bad at assessing trustworthiness, and in favor of businesspeople who are good at assessing trustworthiness. This, in turn, will control the ability of untrustworthy people to enter into contracts which they then run away from.

In contrast, many kinds of robber simply walk up to a complete stranger and threaten him in exchange for his money. So the victim never has any opportunity to exercise his judgment of character. The victim is thrown back on alternative measures, such as carrying a gun and shooting the mugger - and the like.

So we might expect that, over time, society might evolve two distinct ways of dealing with contract breakers and robbers - the first more heavily based on character assessment and reputation assessment (e.g. credit check), the second more heavily based on physical prevention (e.g. locks and fences) and violent retaliation.

If you are running, it is

If you are running, it is usually from something. If it is merely debt, count it as a lesson learned for the lender and a black mark for the borrower. I am no contract attorney, but anything else would seem a bit coercive.

Arbitration of customary law certainly has a market demand.

Two schools of thought

Ask him if he would take up strategic bank robbery if he could get away with it?

Because that is exactly what he is contemplating.

This question illustrates a great divide among libertarians.

On the one hand, there are the libertarians that argue that we should design clear social constraints to guard against fraud and coercion -- and should not otherwise expect people to limit their pursuit of their own self-interest. These libertarians see the world in atomistic terms, with relationships arising and terminating to suit changing circumstances. We may negotiate and enter into an agreement, but each individual retains autonomy to seek to alter the terms of that agreement to the extent that he has the power to do so. Thus in the US, people generally have the power to seek a divorce when it seems advantageous to do so. And in the US, contracts tend to contain many implicit and explicit clauses that govern a relationship – including, for example, clauses that permit contracts to be altered in the event of bankruptcy. All parties are presumed to be knowledgeable of these explicit and implicit terms when contracting. No nanny state; caveat emptor.

On the other hand, there are libertarians that object to government-imposed obligations, but argue that a world without such obligations requires quite a few self-imposed (or informally imposed) obligations. They tend to see the world in a vaguely tribal way. These libertarians value “character,” and often see the world in clear moral terms, with us-vs.-them dynamics. If you and I enter into an agreement, we are now “on each other’s side” against a world of outsiders.

I strive to design public policy around the first option. Ideally, rules would be sufficiently well developed and enforced that people would be free to exploit them to their selfish hearts’ content, because doing so would never cause undue impingement on their neighbors. In other words, yes, feel free to rob banks if you can get away with it; and society should structure itself such that you can’t get away with it.

But the fact that all societies develop informal sanctions and systems of morality suggest that we can never really rely on rules to be a substitute for self-restraint. That is, as we play the role of competitor we have a moral duty to also play the role of referee, at least to some extent. In other words, no, you shouldn’t rob banks even if you can get away with it.

re bank robbery

"Ask him if he would take up strategic bank robbery if he could get away with it?

Because that is exactly what he is contemplating."

Wow - that is the most absurd things I have read in a while.

"They have lost

"They have lost >$200,000"

Um, no.

The asset which they purchased, if sold today, would likely bring $200,000 less than it did when they bought it.

Five years from now, it might fetch $200,000 more than it did when they bought it.

If that latter were to happen, would it be okay for the bank to cancel their mortgage, refund their payments, and sell the house from under them?

They wanted a house. They agreed to buy the house for $X, and they borrowed that $X from a bank on an agreement to repay it with interest. Why should the agreement be any less binding on them than it is on the bank?

"They have lost

"They have lost >$200,000"

Um, no.

The asset which they purchased, if sold today, would likely bring $200,000 less than it did when they bought it.

Everything anyone owns changes in market price every day. The cash in my pocket increased in price today relative to the value of gold. If I owned a house, it would've also changed price today relative to the value of cash and gold.

His $200,000 loss is very real. It has lost that much in market price.

After legitimate bubbles pop, asset prices often take decades to get back to their peak price, if they ever do. Japanese real estate and stock prices are way way below their prices from 20 years ago. There's no way his house is going to be worth $400,000 again (in today's terms) for at least two decades.

The "they're only paper losses" view prevents people from accepting what's happened and makes them lose even more value in the long term.

Two different interpretations

I don’t think Thomas L. Knapp was saying, “they’re only paper losses.” But it’s a little unclear to me what he is saying.

1. Perhaps he’s focusing on the distinction between the loan and the security agreement (mortgage). The loan says that, in return for a loan of $X a borrower agrees to pay $X+Y to the lender. The borrower’s obligation to spend the $X to buy a house, and the lender’s interest in that house as collateral, arise from the mortgage agreement, not from the loan. The change in the value of the collateral may have practical consequences for the mortgage agreement, but arguably does not alter the terms of the loan.

2. Alternatively perhaps he’s focusing on the distinction between debt and equity. The borrower assumes an obligation to repay a lender regardless of what happens to the funds he borrows. The lender does not get the opportunity to derive additional benefit if the borrowed funds subsequently generate a profit; consequently the lender should not bear additional harm if the funds subsequently incur a loss. If the lender is expected to bear a share of those loses, then in effect the lender takes on the qualities of an equity holder and should therefore be entitled to a share of the gains.

I regard each of these arguments to be mostly accurate, but not persuasive regarding the merits of strategic default.

Lenders seek mortgages as a means to enforce loan agreements; the decline in the value of the collateral DOES make a practical difference to a loan agreement. And as a practical matter, all lenders DO have characteristics of equity holders, in that they are exposed to the risk of loss if the borrower can’t repay, all the presumed assurances in a loan agreement notwithstanding. And no, lenders are not entitled to a corresponding share of upside gains. Rather, the lender’s compensation for bearing downside risk is reflected in the interest rate; lenders specify the terms under which they are willing to bear the risk of default for any given borrower when they set their interest rates. Thus I also shed few tears for lenders facing defaulting borrowers; they got what they bargained for.

True, if today’s borrowers default at a higher rate than expected, tomorrow's borrowers will likely see higher interest rates. Does this mean that today’s defaulting borrowers create an externality that is borne by tomorrow’s innocent borrowers? To the extent that lenders learn that they have been underestimate the risk of loans, that’s an appropriate response: Tomorrow's borrowers SHOULD bear a higher interest rate, and they have no basis for feeling aggrieved that today's borrowers got a windfall in the form of inappropriately low interest rates. And to the extent that the market over-reacts and increases interest rates beyond the level justified by the risk of default, that’s the fault of imperfect capital markets, not any given player.

I'll say it is only paper profits and losses until the house is

sold. Did he buy the house to live in or to flip? Was he making enough money so that he could live in the house for the next 10 years and pay the bills? Can he still live in the house for the next 10 years? Then no loss.