Strategic Defaults - Is this OK?

I’ve been seeing a lot of articles like this one lately. With housing prices having dropped so much, I think we’ll be hearing more about it. Do you think that this is an acceptable practice?

I’m coming down on the “It’s wrong” side of this. I understand that lots of folks have financial problems and can’t make their bills. It happens. But to willingly walk away from a financial commitment that you’ve made as a “business decision” when you have the means to make the payments - uh-uh. Can’t get behind that.

Were I in a situation where it was useful, I would certainly consider it. The thing is, some people look at it like they made a commitment to pay back the bank no matter what happens, but that’s not the case. Anyone who knows anything about how banks operate know just how much they think of any sort of honor system. They hold your checks for 5 days not because it takes that long to actually clear it, but because it makes more money for them.

They cash your large checks first because it improves the odds that they will get more NSF charges that way.

The list of things banks do to squeak extra money out of every customer are appalling, and they will use every weasel word in the law and thier contracts to get it.

I see no problem with people turning around and nailing the bank with the terms of the laws and contract that they signed. It’s the least they would do for you…

After all, if they didn’t want to make that loan, they could have chosen not to…that’s how capitalism works.

Despite the slant of the article–misunderstanding the legal use of the word “promise” in much the same way creationists willfully fail to understand the scientific use of “theory”-- why wouldn’t it be?

A mortgage is basically a contract that says “either pay us in this manner or give us these things (the property and perhaps other penalties) in lieu of payment.”

No one is violating the terms of the contract, they’re just choosing the “give us the property” part of the bargain rather than the “pay us.” Presumably the bank considered the two sides of the equation equal (at least on average), or they wouldn’t have written the contract. I don’t think there’s an ethical question here at all. As others have pointed out, if the situation were reversed the bank would be more or less required by it’s shareholders to take whichever path was most profitable.

If defaults were prohibited, interest rates would be lower, because there would be less risk to the bank. So unless banks want to start refunding all that excess interest, they shouldn’t complain when people choose to default.

However, people seem to think you can just walk away and the only damage is a hit to your credit rating. That is true in some cases, but in others, the bank can go after your other assets. It depends on where you live and whether your mortgage was a first, second, etc.

Isn’t the point of the OP that these folks are deliberately not complying with the terms of the contracts they signed?

A contract is a legal obligation, not a moral one. The bank knows the risks involved in the deal better than most consumers. This is not a decision to be made lightly. There are serious and long lasting consequences, worse in some states than others. However, if it is really in the debtor’s best interest to abandon the property, I have no problem with it.

I note with some amusement that the article mostly cites bankers for arguments against the proposition…and that one nutty professor from Georgetown.

So you don’t see a moral component to saying “Sure, I agreed to do X, but now I’ve decided it’s in my best interests to renege.” ?

I note that Googling “contract moral obligation” produces a vast number of texts discussing this as a subject with a very long history.

There’s nothing particularly unusual about defaulting on a contract because it no longer makes business sense to follow through on it. The law and (one hopes) the contract are set up in a way to discourage it, but if you do a cost-benefit analysis, taking into account all the consequences of default, and figure out that it’d be in your interest, why wouldn’t you?

More interesting is the possibility of using the threat of default as leverage for consumers to renegotiate their deal with the bank. It’d have to be a good, credible threat–the cost-benefit would have to tilt appropriately–but given that banks don’t really want to own a bunch of houses, I suspect you might be able to work a very nice deal out of it.

No, I don’t think there is a moral component here because the lender is not operating under any similar moral constraints. If you adopt a position of morality while your counterparty adopts a position of amorality, you simply open yourself up to exploitation. How is allowing yourself to be exploited good for anybody?

Dan Ariely, in his book Predictably Irrational, discusses how “we live simultaneously in two different worlds - one where social norms prevail, and the other where market norms make the rules.” He proposes that “[w]hen social and market norms collide, trouble sets in.” Banks and lenders operate in the world of amoral market norms. For instance, Morgan Stanley recently announced that it would be strategically defaulting in order to get out of a loan obligation (see here ).

A social contract with a friend is a very different beast that a financial contract with a bank, and I think it’s important not to mix the behavioral norms of the two.

Of course not. They wouldn’t put in provisions for what you have to do if you renege if they didn’t expect it to happen, at least some of the time. There’s always an “escape clause.”

And I don’t like the idea that they are trying to make us view a contract as a promise. A promise implies that you will do everything in your power not to break it. A contract is more like “If I break this, I will be punished.” Of course, if the punishment is better than the alternative, that’s the option you should pick.

I did before I went to law school. Even argued the point rather passionately in class. My contracts prof convinced me otherwise. A contract is an arms length negotiation, with each side looking out for their own interests. The creditor assumes the risk of default, and factors that risk into the terms of the deal. To a certain extent, it’s like gambling. Sometimes you roll the dice and they come up snake eyes.

I think that the problem that I have with this practice isn’t so much that it’s damaging to the banks. I’m probably about as far from a corporate apologist as anybody, and I totally agree with the points that others have made that the banks use the law to their own advantage. Hell, who are we kidding? They make the law.

I’m more concerned about this from a different standpoint. My bone of contention here is that this practice is going to prolong the mess we have with housing right now. More foreclosures are a bad thing for us as a society. More vacant and unmaintained houses in our neighborhoods kill values for those who choose to play by the rules. They become an eyesore, and sometimes they attract a criminal element to areas that didn’t already have much of that.

And while we’re taking a “screw the banks because they’re screwing us” attitude, let’s not not forget that as banks get more defaults, credit becomes enormously tighter. While I would agree that we needed to tighten up the lending standards that got us into this mess, I’m concerned that we’re going to crank that valve shut too hard. We can’t run an economy strictly on cash. Access to credit is a big key in making it possible for people to open and expand small businesses.

And those corporate pirates that we all hate so much (present company included)? They need to be kept in check. But let’s not forget that many of us have an ownership stake in them in one form or another. In a lot of ways “they” are “us”.

I think that the practice of walking away from a debt that you can afford to pay strictly based on a cost benefit analysis is exactly the kind of extreme self-interest that’s destroying our society. I’m more concerned about the unwritten social contract than I am about the written contract between a borrower and a lender.

Is it appropriate to look at the actual record of the lender, or is it acceptable to assume that because some lenders are sleazy, all may be treated as if they are?

Well, it’s easy to see how it could be good for the exploiter. (Note that I do not see this as relevant to the debate.)

The fact that it’s expected to happen occasionally and that provisions are made for dealing with this does not inherently make it right - just as laws specifying what will happen to you if you commit assault or rape should not be taken to means that if you are willing to undergo the specified punishment, the crime is then acceptable.

I have nothing really to add other than should anyone think that Oakminster’s position is a minority opinion among people who work in these sorts of field (i.e., law and finance), know that it is not.

Breach of contract is not a crime! Nobody in the law games confuses the two. Punitive damages are not available in contract actions, because, as the managerial class is so fond of reminding people when they lay a pink slip on someone’s desk, “it’s nothing personal, it’s just business.” (Are the delicate moral sensibilities of the Wall Street Journal so vexed when they report about plant layoffs, I wonder?)

Ultimately, Oakminster has captured the situation exactly correctly. Contracts are a tool designed to solve the first-mover problem. The first party to act in a time-consuming contractual transaction does not know whether her counterparty will live up to the bargain. Thus we created contract law and its premise that a breaching party must restore a faultless victim to the position that the victim would have been in had the breach not occurred.

Now it happens that sometimes the rewards of breach are so great that you can pay those damages and still come out ahead–further ahead than you would have had you lived up to the contract. Very eminent (and fairly conservative/libertarian) scholars of law and economics endorse this position—scholars like Richard Posner, Frank Easterbrook, Guido Calabresi, and Alex Kozinski. And while you’re googling “contract moral obligation” for musty old tomes about the 18th century understanding of contract law, you might want to try “efficient breach” for something a little more state-of-the-art.

It has nothing to do with anyone being sleazy. One generally expects a lender to act in material self-interest and I think it’s unhealthy if the borrower does not act in a similar fashion. When a borrower incorporates social norms associated personal obligations into a mortgage contract while the lender operates on a purely market level, the borrower is (pseudo-)voluntarily placing himself in an economically exploitable position.

There’s a difference: those things were wrong well before the law was made. Breaking a contract is only “wrong” because you signed the paper.

My argument is that, since the paper itself tells you what you have to do if you default, I’m only promising to uphold it unless I default.

Think about it. If I say “I promise to walk your dog, but, if I don’t, I’ll have my son walk it for me,” do you think I must do the walking no matter what? No, the “promise” itself contains an alternate that I am allowed to utilize. In fact, in common parlance, it pretty much means I will pick the second option.

Quite the contrary. The contract they signed is you pay or forfeit the house. As several posters have made clear the banks make use of every fine print clause in the constract you didn’t read (no, neither did I) to screw you in every way possible. The reason for the substantial majority on option 1 is that people see debt as a moral obligation, not a contractural one. The only time a debt becomes a moral obligation is when there is a close relation between the lender and borrower. For example, when I moved to the house I have been living in for nearly 38 years, I needed $5000 to be able to take over the old mortgage, at considerable savings to myself. I borrowed from a good friend who had the money sitting in a bank account and I paid him essentially the bank interest rate. That was a moral obligation and I repaid it just as quickly as I could. On the other hand, after my brother died his widow asked for a $5000 loan until she got the insurance money (and he had about $2.5M worth of insurance). I gave it to her, no questions asked, with no contract, and that was almost 11 years ago and she has made not the slightest move towards repaying (and I’ll be damned if I am going to ask).

But banks are amoral and so am I in my dealings with them.