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.