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?

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

My reflections on this topic ended up being far too long for a single blog post, so I’ve divided it into three for easier reading. I’ll post them over the next three days).

Part I: Strategic Default: What is it, and why would anyone consider doing it?

Banks, once the paradigm case of fiduciary responsibility, have taken quite a reputational hit in the past half-decade. Where once the banker was the very stereotype of responsible, conservative financial management, whom you’d trust with your money more than you’d trust yourself, many people now see banks as just one more institution interested in nothing more than taking your money from you. While this is a broad generalization, it’s not without some basis in fact. Mortgage lenders and mortgage brokers, particularly, played a substantial role in the current financial crisis. However, an emerging trend called “strategic default,” where homeowners who are capable of repaying loans walk away from their homes because of a drop in investment value, takes unfair advantage of this perception and could possibly endanger the entire home loan ecosystem. Because of the recent reputation of dirty-dealing in lending, though, banks need to very careful in how they analyze and respond to this trend.

Strategic default, as it has come to be known, is when a homeowner who has the means to pay his or her mortgage stops paying their mortgage and allows the bank to foreclose. For example, let’s say a family took out a $400,000 loan in 2005 to buy a house at the peak of the market. They were able to pay the loan at the time and it is still within their means to do so. But let’s further assume that the value of the house, should they sell it today, would be $250,000 (a drop that would be entirely likely in some parts of California). The “strategic” defaulter, seeing that they have $-150,000 in equity, decides that letting the bank have the house and taking the 7 to 10 year hit on his or her credit is worth the $150,000. They know it would probably be 7 to 10 years before they recover the original value of the house, to say nothing of the thousands payed in interest.

Looked at from a purely financial point of view, it’s easy to see their point. Let’s look at the math. In May 2005, the average interest rate for a 30 year fixed rate mortgage was 5.75. Let’s use the following assumptions:

House price: $420,000

Down payment (5%): $20,000

PMI: .5%

Taxes: 1.25%

Current value: $250,000

Rate of return for the next 10 years: 4%

A homeowner would be likely to analyse his or her cost benefit analysis as follows:

The value of the house at the end of the period: $370,000

Total payments: $418,000

Investment value $-48,000

It should be pointed out that this isn’t a very sophisticated way of doing a cost benefit analysis, but I think it is pretty close to the intuitive way people think about their housing investment. A good CBA would consider the pre-2010 payments sunk costs, take into consideration the value of housing for that period, and would include transaction and opportunity costs, etc. But still, I suspect it’s this sort of analysis that leads people to walk away from their homes. They think that for the $418,000 of payments they will have made, a $48,000 loss is a pretty bad return. And who could blame them for thinking that? But a mortgage is not just a financial, but a legal and ethical transaction, as well.

While there has likely always been a small percentage of homeowners who default on their loans for investment reasons, this number has remained small for few reasons. First, since the early 90s, the real estate market has almost always been a good investment. Over that period, there was never a period where the overall market dropped ( see graph for illustration of this phenomenon). Second, homeownership has traditionally held an exalted place in the American psyche and there has always been a good deal of social pressure to own a home among the middle and upper classes. Finally, in a another manifestation of social pressure, anyone who walked away from a home for purely financial reasons would be ostracized as a thief or, at the very least, a deadbeat.

The 20-40% market drop, in some places more, removed the investment incentive. While this has happened before, however, and there was not a wholesale abandonment of homes. The primary difference is that the fallen reputation of banks has provided a sort of excuse for people who would otherwise have been ashamed to walk away from their homes. The assumption of superior ethical standing has moved from the lenders to the borrowers. Now a person who is foreclosed upon is seen as a victim rather than a perpetrator, regardless of the actual circumstances of th default.

(Tomorrow: Risk and Consequences)

The relationship between compliance, risk, and ethics

Although he claims not to like the word “ethics” because he feels it denotes too firm a demarcation between permissible and impermissible activities, David Chillders does nice job of linking ethics, risk, and compliance in this 50 minute talk. While I disagree with some of his intermediate conclusions, the founder of EthicsPoint is right track and this is well worth a listen if this topic interests you.

http://www.youtube.com/watch?v=n45W60zxiGk

I’m finding the issue of strategic default to be a rich one for reflection, so the blog post on it will be posted later today.