Double Standard

Recently in class I mentioned that at times it can be a good business decision to default on one’s loan obligations, and that doing so is not necessarily a sign of poor moral character. I recognized that my students–undergraduates all, mostly sophomores–have neither the business nor life experience to truly grasp my point, and even if they did they would not necessarily agree with it.  It’s legalistic, based as it is on non-recourse financing, bankruptcy reorganization, rejection of executory contracts, and other remedies that show a binding promise is not necessarily binding. It was not essential to our discussion and I didn’t belabor the point.

I thought of it again upon read James Surowiecki’s “Living by Default” in the December 19 & 26, 2011 New Yorker. (Keeping current with The New Yorker would require that I cut back on working, working out, sleeping, or other reading.) Surowiecki mentions that American Airlines chose recently to file for bankruptcy:

Declaring bankruptcy will trim American’s debt load and allow it to break its union contracts, so that it can slim down and cut costs. American wasn’t stigmatized for the move. Instead, analysts hailed it as “very smart.” It is now generally accepted that when it’s economically irrational for a company to keep paying its debts it will try to renegotiate them or, failing that, default. For creditors, that’s just the price of business.

Seeing that strategic defaults are an acknowledged business risk dealt with by contract terms, negotiations, and restructured business deals, Surowiecki asks why more homeowners with underwater mortgage debt don’t walk away from their loans?

The bursting of the housing bubble has left millions of homeowners across the country owing more than their homes are worth. In some areas, well over half of mortgages are underwater, many so deeply that people owe forty or fifty per cent more than the value of their homes. In other words, a good percentage of Americans are in much the same position as American Airlines: they can still pay their debts, but doing so is like setting a pile of money on fire every month.

It’s a valid question. Surowiecki provides a few practical answers–dealing with the consequences a loan default is hard work, many homeowners have unrealistic views of the their home’s value–but says the biggest problem is the social stigma of defaulting on one’s home mortgage:

According to one study, eighty-one per cent of Americans think it’s immoral not to pay your mortgage when you can, and the idea of default is shaped by what Brent White, a law professor at the University of Arizona, calls a discourse of “shame, guilt, and fear.”

If you are interested Surowiecki makes the point far better than I made it in class discussion.

5 thoughts on “Double Standard”

  1. My high school teacher once told me about how medical school graduate would go to school and file for bankruptcy after they graduate to avoid the loan obligation. But  i think when people just taking loans and not paying it back it causes other people problems. Once i was at the bank, the employee there says i should have a credit card earlier so i can start to build credit for my account. I am not exactly sure about how the “credit point” system works, but i guess be a good person and paying back loans are what we have been taught for the past 12 years for our education, and organizations like the bank  and insurance companies do have some kind of measure for your “credibility”

    1. I wouldn’t generally support someone borrowing money for law, medical, or any other professional school and then filing for bankruptcy just to get out of it.

      David

      David Randall
      Senior Lecturer, Boston University School of Management
      Room 644
      Boston, MA 02215
      617 353 9644
      A Foolish Consistency blog
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  2. I did not think I would comment any time soon but I also did not think you would discuss a James Surowiecki article. I should start by saying that Surowiecki is one of the more thoughtful and insightful journalists in the world. His book, “The Wisdom of Crowds”, is a must read. I am obviously a fan of his.
    That said, this  article is not his finest work. For example he says studies suggest, “Only 1/4 of all foreclosures are strategic”…this statistic has no context. Is this low? Is this high? Where was it pre-2007? What was the highest it had ever been? I’d bet that this level of strategic defaults is the highest we have ever seen in American history. Additionally, I would have liked to have seen a graph showing the notional number of strategic defaults throughout the last 10 years. The trend would have certainly been up, and as that trend rises the stigma attached to defaulting on ones mortgage diminishes and as the stigma diminishes more people will be inclined to strategically default…a virtuous cycle of people walking-away and making sound personal business decisions… unless, of course, you’re a bank.

    “In some areas, well over half of mortgages are underwater, many so deeply that people owe forty or fifty per cent more than the value of their homes.”
    He fails to address an important question: how many of these aforementioned homeowners are “strategically behind on their mortgage payments?” The eviction process for banks is a nightmare. In some states, tenants are enjoying anywhere from 6months – 24 months of free housings before banks are able to get their shit together and remove them from the homes…why would you strategically default when you can enjoy free housing?

    “In other words, a good percentage of Americans are in much the same position as American Airlines: They can still pay their debts, but doing so is like setting a pile of money on fire every month.”
    What is the definition of, “A good percentage of Americans”. This sentence is shit. 

    Your grading standards must have become more relaxed since I was in LA245. If I had provided such weak supporting data for any argument, you would have ripped me a new…

    I get the jist of the argument and his complaint about the stigma attached to strategic default for individuals versus corporations. But his argument is not well constructed.
    By the way, since Surowiecki failed to do the leg-work, I’ll share a piece of data…a survey at the University of Chicago last year found that roughly three out of 10  mortgage defaults in 2010 were by homeowners who could afford to make their payments, up from 22 percent in 2009. When the data for 2011 comes out, I’m sure that number will have risen again.Source: “Strategic Defaults are Coming”. http://www.trulia.com/blog/tomramsey/2012/01/strategic_default_s_are_comingProfessor Randall, the next thing that should happen after you are done reading this is that you walk down to the Registrar’s office and fix that grade. A-? Gimme a break.

    1. Welcome back. I hoped posting about this Surowiecki article would move you to comment. I agree that Surowiecki’s article–and
      my re-characterization of it–lack the analytic rigor necessary to make them more than conversational hares let loose for others to pursue. The earlier comment about a med student filing for bankruptcy to discharge student loans raises hard-to-answer questions, which you raise as well: what, exactly, makes a default strategic? The answer must be something more principled than “it’s strategic because it gets me out of a loan I now regret.” What objective criteria might be used to define “strategic default?” There’s also the powerful moral hazard argument–as you put it, “as that trend rises the stigma attached to defaulting on ones mortgage diminishes and as the stigma diminishes more people will be inclined to strategically default…a virtuous cycle of people walking-away.” One can also argue that an individual homeowner’s strategic default is nothing like American Airlines’. AA has millions of shareholders, billions in debt, billions in assets, and owns a critical piece of the world’s transportation infrastructure. To put AA’s and the mortgagor’s default decisions on the same plane (pun intended) is misleading–their differences far outweigh their similarities.

      David

      David Randall
      Senior Lecturer, Boston University School of Management
      Room 644
      Boston, MA 02215
      617 353 9644
      A Foolish Consistency blog
      Course Materials
      David Randall’s BU
      Calendar
      Twitter Feed @darIandall1953

  3. I’m not that much of a internet reader to be honest
    but your sites really nice, keep it up! I’ll go ahead and bookmark your website to come back
    later. Many thanks

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