The Ethics Of, and Response To, "Strategic Default" (part 2)

Part 2: The Ethical and Systemic Consequences of Strategic Default

For this reason, mortgage lenders should be very cautious in their approach to dealing with this trend. Additionally, there is reason to think that there could be systemic effects should this trend become widespread. If strategic default were to go to 2 million, the risk profile of mortgage lending in the US would change so significantly that it could result in much higher interest rates for all borrowers or, in an extreme case, could see lenders exiting the business for lower-risk places for their capital.

To see why I think there could be systemic effects from strategic default, it’s necessary to understand the risk sharing profile of home lending. There are several kinds of risk involved in making a loan, market, default, and financial. Market risk is the possibility that the property being bought by the homeowner will decrease, rather than increase in value (or, perhaps, even just fall short of the cost of capital, in this case the interest rate of the home loan). Default risk is possibility that the borrower might not repay the loan. Finally, financial risk is the possibility that money the bank uses to lend to the homeowner will become more expensive than loan itself (i.e. the bank’s cost of capital exceeds the interest rate on the loan.)

As in most financial transactions, the holder of the risk gets the rewards for that risk. In the case of mortgage lending, if the house goes up in value, the homeowner gets to keep difference (minus taxes, etc.). If the loan gets repaid, the bank (or holder of the loan in the secondary market) gets compensated for the default risk by interest payments. The same goes for financial risk. If the opportunity cost of the loan was lower than that of other investments, it’s a good investment.

The major problem with strategic defaults, from both ethical and financial perspectives, is that they transfer the market risk from the party who gets the benefit if the risk comes good (the homeowner) to a party who gets gets no benefit and in fact sees nothing but downside risk (the lender). Since the lender isn’t expecting the downside market risk when making the loan, that risk isn’t priced into the loan. The lenders would want either to share in the upside risk (by sharing in the profits of a sale if the market went up) or price the market risk into the into the interest rate (by raising it considerably). But since neither of these scenarios was taken into account went the loans were made, I’d argue that transferring risk to a party that isn’t compensated for it is unethical.

Even more concerning than the losses to banks is the possibility of strategic defaults becoming widespread. While I’m not one to prophesy doom for the worlds most resilient financial system, strategic defaults could have a severely destabilizing effect on the mortgage lending market if their prevalence rises. Without structural changes in the way home loans apportion risk and reward, mortgage lending would become a very unattractive business indeed.

This could play out in a number of ways. Risk-averse investors/lenders could leave the market. The process and qualifications for the getting a home loan could be much more stringent, pushing housing prices down. The most likely scenario would be a wholesale rise in interest rates to account for increased default risk. Here’s where the strategic defaulters would be forcing us into a “tragedy of the common” situation, thereby doubling their ethical . The short-term individual gains of the defaulters would cause a structural change in the way interest rates are calculated. This would result in everyone paying higher interest rates for their loans.

In short, from an ethical perspective, the strategic defaulter is a triple loser. First, they break a contract made in good faith. Second, they cause others to become unable to get home loans as banks tighten their lending standards. Third, as the price of strategic defaults gets priced into the interest rates charged on home loans, they cause many people who are ethically untainted pay the price of their default.

This raises the question, of course, if there are ethically defensible reasons for breaking a contract like a home loan. While this may controversial in some cases, it’s pretty clear that there are situations when a borrower shouldn’t be held ethically (or financially, for that matter) liable for walking away from a loan. If the loan was made under fradulent pretenses (by the lender, that is), for example, a borrower shouldn’t be held to the contract. Similalry, if undue or inappropriate pressure or misinformation was used to get a borrower to take out the loan, I think we’d say they should be released from responsibility. Also, the ethical approbrium we would level at someone who has lost a job or has seen their ability to pay a loan decreased through either macro- or micro-economic circumstances would be diminished. Thus, there are clearly cases when it’s not ethically questionable to default on a home loan and banks should be clear about dilineating the different classes of borrowers when dealing with the default.

That said, under no traditional ethical framework would strategic default be approved of. Clearly, all foundational ethical systems have “no stealing” and “no lying” dicta which preclude strategic default. Virtue ethics, in which one asks if this is something a virtuous person would do, is (as always) a little less definite on this question, but it’s hard to imagine a person walking away from a contract for purely economic gain being considered a paragon of virtue. A deontological approach, especisally that of Kant’s Categorical Imperitive, would clearly make strategic default unethical. In Kant’s approach, we try to imagine a world in which everyone acted in the way we are examining. If it becomes impossible, than Kant would say it’s unethical. Obviously, if everyone defaulted on a loan that lost value, no one would make loans any more, which would make taking out loans impossible. Finally, under a pragmatic/utilitarian ethical framework, which looks at the action in terms of how well it works out for the everyone, strategic default would be considered unethical because, due to the “tragedy of the commons” effect, far more finanical pain is caused by the defaulters than is gained by them.

Tomorrow, part 3: Playing Heavy and/or Creative Solutions: What Should the Banks Do?

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