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Friday, May 7, 2010

Mortgages, Promises, Contracts, and Strategic Default

In a recent article and response in the City Journal, Is Strategic Default a Menace?, Prof. Luigi Zingales (previously criticized here) of the University of Chicago's School of Business and Prof. Brent T. White of University of Arizona Law School, debate the propriety, morality, and legality of strategic mortgage default—the increasingly popular, but still surprisingly rare, practice of home owners whose mortgage balance exceeds their house's fair market value to just walk away: stop making mortgage payments and forfeiting the house to the bank holding the mortgage.

What surprises at first is that a scholar, deeming himself qualified to publicly opine on a subject, would prove both capable of either sowing or displaying so much confusion about such a non-trivial, but perfectly cognizable subject and willing to propound so many statements and principles that would to a reasonable, logical observer seem outside the realm of defensible discourse. What surprises even more is that two scholars—at least one associated with one of the most distinguished universities in the world and at least one a qualified lawyer—would be willing to do so repeatedly.

But let's start by clearing away some of the underbrush.

First, almost all housing defaults observed in excess of what would be observed in an ordinary recession of the same length and severity in fact are strategic. If unforeseen and unforeseeable circumstances, such as a cyclical job loss or sudden illness, render an owner unable to meet its mortgage obligations default may be unavoidable, not a strategic choice. But that the fair market value of a piece of real estate may have also dropped dramatically has no impact whatsoever on the owner's ability to make its payments. Every home owner who walks away from a mortgage because real estate values dropped below expectations made a strategic choice to game the system—either today or when entering into the mortgage contract based on the assumption that payments would only be made if housing prices just kept increasingly rapidly forever.

Second, a mortgage is not a promise, but a contract. As every first year law student knows, and Profs. Zingales and White ought to know, a promise does not a contract make. A promise creates a general, moral obligation; a contract creates something which is both more and less: an exact legal obligation (or to be precise, at least a pair of such obligations) enforceable through the judicial system. These are not the same and treating them as one and the same, as in particular Prof. Zingales is inclined to do, creates nothing but confusion and false conclusions.

Having disposed of these preliminaries and identified the right categories, let's analyze mortgages and strategic default:

The legal obligations created by a home mortgage contract are many and vary greatly from jurisdiction to jurisdiction, but there are only two big ones which, with one crucial exception, are the same everywhere:

  1. The bank obligates itself to provide the necessary funds for the purchase of the home. The bank fulfills its obligation right at the beginning of the contract term and failure to do so may occur anecdotally but does not appear to be a frequent or pressing social concern; in cases where this obligation is broken legal remedies are clear and pretty uncontroversial.

  2. The home owner obligates itself make agreed-upon periodic payments to the bank, until the principal amount and agreed-upon interest, is paid off or to surrender the collateral, that is the house, to the bank. It is here that the important distinction between jurisdictions enters: In some (so-called non-recourse jurisdictions), that is the entire legal obligation of the home owner. In others (unsurprisingly called recourse jurisdictions), the (former) home owner is also obligated to pay the balance between the value of the home when surrendered and its remaining legal obligation.

Now it can fairly be debated whether it is wiser for a jurisdiction to be recourse or non-recourse, or whether this is something that the mortgagor and mortgagee should just agree upon on a case-by-case basis as they enter the contract (the latter is what this author would counsel—not that this policy opinion matters for anything that follows). What cannot be fairly debated is whether both parties knew or should have known what kind of mortgage contract they entered into. Whether the jurisdiction where the home is located is recourse or not is well-settled law. It rarely changes. Even more rarely does it change retroactively to affect contracts which were entered before the legal change. In fact, I am unaware of any instance of retroactive change in recent decades (that is, any which could have affected any of the mortgages involved in the current crisis).

So both sides, bank and homeowner, knew or ought to have known exactly what they obligated themselves to do when they signed the contract. Moreover, the market for mortgage contracts is highly competitive from both sides: there are many competing banks and many competing home buyers. In such a competitive market, you'd expect any advantage given to one side (such as non-recourse to home owners) to be counter-balanced by a statistically equal advantage given to the other side (such as higher interest rates in otherwise identical circumstances). So, if non-recourse has a value to home owners, they paid and the banks received a corresponding premium for the option to default strategically (in financial terms, a variable strike-price put option on the collateral).

Hence, Prof. Zingales has no just basis for morally or legally condemning home owners who exercise the option to default strategically in non-recourse states. They bought that option when they entered upon the mortgage. They paid for it with every mortgage payment they made. They broke no promise when they exercised that option. They did not even violate their legal obligations. By returning the house, they fully lived up to them. (Vandalism or theft of fixtures which have legally become part of the property—as has been reported to occur in some cases—is of course not excused by this. Trashing the property of belonging to somebody else is morally and legally wrong, regardless of whether it is the repossessing bank's or your neighbor's.).

Now Prof. Zingales may argue that banks dramatically under-priced the put option which is part of any non-recourse mortgage contract. Perhaps he is right. Perhaps bank managers, quantitative analysts, and policy makers all made this investment error. If so, they deserve to be demoted or fired, the investors which failed to oversee them properly to take a financial bath, and their regulators to take the appropriate level of condemnation.

However, bankers' failures to understand and properly price their contracts is no more excuse to let them out of their obligations than it is in any other case. If we are willing to hold all legally competent adults to the terms of the deals they freely entered, and a viable law of contract requires that we do, it seems bizarre to take outrage at applying this same principle not just to the penniless and semi-literate, but also sophisticated bankers who priced mortgages in non-recourse states. If they made a bad deal, that was a business misjudgment and they and all whom they are answerable to, including top management and investors, will have to live with.

In response, Prof. Zingales (and perhaps Prof. White, if he gave the matter some thought), might argue that no sane lender will write a mortgage in a non-recourse state without a very healthy down-payment cushion and high interest rates. Hence the young and the poor, who reportedly have the largest difficulty in coming up with sufficient down payments, will be locked out of the housing markets and just have to live in rental housing until they have accumulated a sufficient down payment.

So be it. Perhaps this will convince populist legislatures who enacted non-recourse laws in order to protect the poor and downtrodden against avaricious bankers to change their minds when they realize that the price for that protection is reduced homeownership by that same favored group. Or perhaps not, as legislatures find this price worth paying. But in either case, we are far more likely to get decent policy on recourse if legislatures will finally be held accountable for both side of a policy, rather than being empowered to view non-recourse as a free lunch.

So much for Prof. Zingales—on to Prof. White who advocates strategic default for owners of homes worth less than their mortgages. As argued above, that is fair enough in non-recourse jurisdictions. But Prof. White makes no distinction between recourse and non-recourse jurisdictions and the different obligations homeowners incur in different states.

He justifies strategic default in recourse states as follows:

In [recourse] 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. ... 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.

In other words, because the bank's legal expenses of enforcing the contractual obligation may be too high to be worthwhile, it is acceptable to ignore the obligation! One can scarcely believe that a progressive legal scholar would endorse such a principle, if indeed it is a principle, rather than a convenient good-for-one-use only verbal distraction.

Does Prof. White counsel businesses to violate their contractual obligations whenever they can get away with it because the other side cannot economically obtain a judgment against them? How about a bank which takes unauthorized nuisance fees out clients' accounts? A dry cleaner who demands a couple extra dollars beyond the agreed price in return for the cleaned clothes? A landlord who groundlessly declines to return a deposit? A diner who dashes rather than pay his check? In all of these cases, there need be no criminal intent to deceive or trickery—just a strategic decision to keep the money because one can and it is not worth suing over. Does that make the practices right?

To ask these questions is to answer them. Of course he would not endorse such practices (or at least my searches missed any articles he has written in their defense). Violating contracts is commendable if done by members of groups favored by Prof. White; it is an outrage if done to members of groups favored by Prof. White. Such an instrumentalist perspective on morality or law is destructive to both. Prof. White's students and readers would do well to keep that in mind when evaluating his statements.