Norms of credit

Megan McArdle has responded to my earlier piece on strategic default. Before offering a substantive reply, I’d like to emphasize that my piece was not intended as a “slap down”. If there was anything uncivil either in tone or content, I apologize for it. I often disagree with Ms. McArdle, but she is a talented writer whom I’ve enjoyed for years. I’m pleased to be one of her “little chickadees“. I hope she’ll forgive that I chirp and peck.

Moreover, I think I share McArdle’s deep concern, that a collapse in the norms of commerce will leave us with more cumbersome and substantively worse means of regulating ourselves than we’ve had in the past. We disagree, I think, about who is responsible for the putative collapse, how far along it is, and what we ought to do going forward to regain a desirable equilibrium. I think that the collapse is already upon us, and that the proximate cause is a failure by businesses — especially though not uniquely in the FIRE industries — to live up to tacit social bargains. I blame that in part on a corrosive but remunerative ideology that denies those bargains bind at all. I suspect Ms. McArdle would tell a different story.

Communities regulate themselves via a wide variety of tools, ranging formal legal arrangements to unspoken social norms. Laws are much more visible than norms, but norms carry most of the burden of helping us get along. In the language of economists, norms make markets more complete, by rendering practical contracts too complicated and pervasive to be written and enforced by courts. If I lend a friend some money on a handshake, there are a thousand circumstances under which I would agree to delay in repayment, circumstances in which we would both agree that repayment has become justifiably impossible, and circumstances in which my friend might accelerate her repayment and overpay on the interest with gratitude. To delineate all of those contingencies in a formal contract would be impossible, and attempts to do so leave us with phonebook-length legal documents that make a mockery of the phrase “meeting of the minds”.

My view is that a “good society”, both in a moral sense and from the perspective of economic growth, depends much more on the depth and stability of its tacit norms than on its laws and formal institutions. But norms and laws are interrelated. If a society is to be stable, the two must reinforce one another. Norms and laws are complements at a macro level precisely because they are micro-level substitutes. Norms directly substitute for legal text. They “fill in the blanks”, permitting contracts and laws to be concise and intelligible, yet equitable under a wide variety of circumstances. Since legal arrangements that are unintelligible to those they bind cannot be legitimate, the capacity of tacit norms to stand in for textual complexity is an essential complement to a system of laws.

I think the fight over “strategic default” is really about a collapse in the normative arrangements surrounding reputable business. Ideas have consequences, as they say, and I do think that the theory of business that Friedman helped popularize were corrosive. I don’t condemn him personally for that. His views were sincere, and I was once enchanted by them. But we are where we are.

McArdle writes:

[W]e treat business behavior as different from personal behavior…. [W]e’ve lived in a world where profit-maximizing corporations operate by different normative rules from individuals for 150 years. It may be that the norms to which we hold corporations aren’t the right ones — indeed, in the case of things like overdraft fees and credit card rate games, I think it’s very clear that they’re not, and the banks have only themselves to blame when we decide to handle the problem legally instead. But that doesn’t mean that we should therefore abrogate the norms by which our personal lives are conducted.

I think that she is almost right, but she misses something. Businesses have operated and should operate under very different norms than individuals in their interactions with one another. We have, and have long had, the expression “it’s just business”. When spoken by one businessman to another in the context of even a tragic transaction, like calling in a loan that will force a firm to fold, we recognize the words as legitimate, a kind of apology. But if a businessman uses the same phrase while creating trouble for an individual in her role as customer, tenant, or borrower, it marks the businessman as, well, a jerk (to use McArdle’s very excellent descriptor). Behavior at the interface between businesses and individuals in those roles is supposed to be governed by interpersonal rather than intercorporate norms. Expectations of reciprocity still apply. There have always been businesses that sought every legal cover to profitably mistreat people. But such businesses used to be disreputable.

As McArdle acknowledges (I think) with respect to revolving debt, over the past few decades the financial industry has increasingly applied the norms of hard-nosed business to its interactions with customers. Certainly, a home mortgage to an unrelated party is too high value and dangerous a transaction to be regulated by social norms alone. Lengthy contracts are necessarily involved. But that doesn’t absolve a business from its responsibility to craft financial products in a manner that conforms to interpersonal expectations of fair-play. Along a whole variety of dimensions, the financial industry has increasingly violated those expectations. Lenders drafted contracts with fees and other “revenue enhancers” that borrowers are unlikely to fully understand, and profited when borrowers managed them poorly. They enthusiastically marketed loans to individuals whom they were perfectly able to foresee could not easily bear the debt, against collateral whose valuation they knew to be dodgy, then sold those loans via circuitous paths to investors who literally could not know what they were buying. Mortgage lenders suborned appraisers to soothe both buyers and funders with overoptimistic valuations. The normative breakdown went both ways: individuals preyed on businesses too. The gentleman receiving large commissions selling unsuitable loans, perhaps prodding the borrower to overstate his income, may have been betraying his employer (or not, depending on who was ultimately going to bear the risk of the loan). Certainly the ruthless flipper was violating interpersonal norms when she took a mortgage she knew she could not afford, gambling that a huge upside if prices rose was worth a downside limited by non-recourse or bankruptcy. But she was hardly alone, and she could be forgiven for believing that those norms no longer applied at the interface between banks and customers. They did not.

One group of people who did not violate traditional norms during the course of the credit bubble is the ordinary homebuyer who bought at the top of the market without forming an opinion on valuation, trusting market prices and professional advisors. Most homebuyers are not market timers: they purchase when the circumstances of their own lives make homeownership attractive, and take regional prices as given. Certainly the momentum of home prices affected Joe Sixpack’s (or G.I. Joe’s) buy vs. rent decision. Nevertheless, this group had the least culpability for the malfunctions of the credit market yet they are bearing a disproportionate share of the costs. McArdle thinks it would be desirable, from a social perspective, to reinforce norms under which borrowers have a moral obligation to pay. I would rather lenders ensure that loans where it would not be mutually advantageous for the borrower to pay are rare. To uphold McArdle’s norms on the backs of people who were drawn into a speculative bubble not of their making, whose “banking relationship” consists of a note that has been sold and resold multiple times, and whose risks are legally shared with other parties that have not hewn to any standard of good behavior, is simply unjust. Even if they could bear the cost. Even if they buy new furniture with the savings.

I’ll end on an irony. I think that underwater homeowners ought to walk away from their loans for the very same reason McArdle wants us to consider them jerks for doing so. We both want to see norms we consider valuable enforced. I think that banks violated a great many norms of prudence and fair dealing in their practices during the credit bubble, and that they violate the fundamental norm of reciprocity by fully exploiting their own legal rights while insisting that borrowers have a moral obligation not to exercise a contractual option. In order to strengthen norms I consider crucial, I hope transgressors face legal and social consequences (strategic default and reduced shame attached to default) that will alter their behavior going forward. McArdle values a norm that I think most of us share in interpersonal settings, that a person should make every possible effort to pay back money he has borrowed. She also wants to create consequences for transgressors, social costs via a consensus that those who walk away by choice be considered jerks. We have different preferences regarding the kind of world we want our normative frameworks to support: McArdle favors a world with both easy credit and easy bankruptcy. I favor the easy bankruptcy, but not the easy credit. I think that debt arrangements are hazardous and should be entered into only with great care. I don’t consider increasingly leveraged homeownership and aggressively accessible consumer credit to have been positive developments. As a practical matter, I think we must rely on creditors rather than potential debtors to differentiate between wise and unwise loans. So I consider it a feature rather than a bug that holding creditors accountable will encourage them to think twice before sending out convenience checks. Norms, like laws, are always contested. McArdle and I have very different worldviews, and that is reflected in the different norms we are each trying to reinforce.

Afterthoughts: McArdle suggests that in my previous piece, I misread or misrepresented Milton Friedman. I don’t think I have. Interested readers might review Friedman’s essay and decide for themselves. The piece is powerfully argued. Friedman does try to carve out exceptions for “ethical custom” and “deception”, but I don’t think those caveats withstand the force of his argument when there is even a hint of a shade of grey. I’ve written a bit more on this in a comment. (If you are new to Interfluidity, you may not know that the commenters here are far more insightful than the host. The comment sections on the two previous pieces on “strategic default” — here and here — have been excellent.) Also, a while back, The Compulsive Theorist had a couple of good posts on norms and the financial crisis, here and here. Several of the links above are to pieces by Tanta, whom I miss.


38 Responses to “Norms of credit”

  1. JKH writes:

    We have two competing moral default philosophies – default as last resort, or ruthless default. What I haven’t seen yet is how two different potential option settings – non-recourse versus recourse – may affect the choice between the two competing default philosophies. E.g. McArdle alludes to consequences for the option setting norm should ruthless default become the exercise norm. What are the arguments before the fact?

  2. Steve Randy Waldman writes:

    JKH — I think that McArdle would suggest, quite reasonably, that the combination of legal non-recourse and a strong norm that default is a last resort is ideal, because it defines a de facto option that would be difficult to write down, and based on a combination of two underlyings: the value of the property and indeterminate life circumstances. Since default only occurs in the (relatively) unlikely case that both underlyings fail, banks should feel comfortable lending easily. But there would be no way to intelligibly write the “indeterminiate life circumstance” option. That could mean loss of a job, attachment of some unexpected legal liability for which a person was uninsured, a medical issue, etc. So the combination of a strong norm and a weak contract is optimal to her: it permits easy credit / easy BK, but maintains the safety valve.

    But, I dislike this option, because it lets banks too much off the hook of evaluating the economic project for which credit is being provided. Any debt will default under “last resort” circumstances, but I dislike a world in which many people are bound to carry and service burdensome levels of debt as the shadow of past consumption, that funds no current benefit. My view is explicitly paternalistic: I think that debt is something that we know people will make time-inconsistent decisions about, and that those poor decisions (ex post) lead to serious social and personal harms. I want creditors to be in jeopardy of default if they lend into poorly secured, seriously time-inconsistent projects. Marketing vacation loans, for example, strikes me as something banks should broadly get burned on. That’s not to say that all vacation lending is bad — some people can afford to finance a vacation without it being burdensome, and the option to default should be sufficiently “out of the money” (as it is under implicit nonrecourse due to credit ratings) that people are willing to bear mild burdens from past consumption. But I think it is the responsibility of creditors to make evaluations of the wisdom of the loan from the perspective of debtors over the full period of the credit extension.

    Recourse eliminates options, and enforces “default as last resort”. Non-recourse makes both of the aboe philosophies plausible. But I would argue that McArdle’s preference, even if it is desirable, is only sustainable if creditors generally behave very scrupulously with customers. Norms can be powerful, but that power derives from legitimacy in the context of cultural narratives. Narratives like “individual responsibility for valuing a home” breakdown when there has been a housing bubble enthusiastically cheered on by every power that be. The story that you should repay like you would want to be repaid breaks down when your counterparty turns into an unreachable, unpredictable, and unpleasant bureaucracy, very unlike you. (Apparent economies of operational scale in lending might be counterproductive given the damage they do to the normative framework under which people understand their obligations.) The story utterly collapses if your counterparty knew the loan was bad and was predatory in framing the transaction, if it engaged in massive fraud, and sucked money from taxpayers despite trumpeting an ideology of private initiative and reward.

    I’m glad to see the EZ-credit ’00s, come to an end, but even if I lamented that (as McArdle seems to), I think the damage has already been done, the scaffolding that sustained “default as last resort” even in the face of legal nonrecourse is damaged beyond repair.

  3. someone writes:

    > “banks vacation loans, for example, strikes me as something banks should broadly get burned on”

    why that??
    imho banks and individuals (except those who have been put under tutelage) must bear all consequences of their decisions.

  4. [...] and forth on the idea of cultural norms and strategic defaulting. (In order, Megan, Steve, Megan, Steve. I really enjoyed Steve last post there, but they are all worth a read.) It starts with McArdle [...]

  5. JKH writes:


    Sorry, I’m in terribly slow comprehension mode at this particular time. Apologies if I’m repeating stuff here.

    I think you’re saying that the threat/risk of strategic default must be normalized in part because this is necessary in order to invoke appropriate discipline on credit risk management. Then I’m assuming it goes without saying that the threat of strategic default can only be brought to bear if the non-recourse structure is retained. The reason for that is that the put option is of greater value to the defaulter and of greater cost to the creditor, which is what puts pressure on the creditor to do a better job.

    It seems that creditors and governments implicitly view the current arrangement with the higher expected barrier to option exercise (last resort default) as a sort of quid pro quo for the greater moneyness of the non-recourse option (compared to the recourse option). McCardle suggests that your lower barrier to option exercise (strategic default) would push the industry toward recourse as an economic response. Then I think you must be saying that the existing non-recourse must stay as a matter of policy, with a new lower barrier to option exercise (acceptability of strategic default) – both factors are required jointly to force more discipline on the credit industry.

  6. dsquared writes:

    Some might think it refreshing that someone who has spent their entire career implicitly arguing that there’s one rule for corporations and the rich and one rule for the rest of us would decide to do so explicitly, in so many words. But I find myself curiously unrefreshed.

  7. But What do I Know? writes:

    Thanks for this excellent discussion. I think you have something when you write about “traditional norms” as a organizing principle for society–or, as Samuel Johnson put it, “the Law is an Ass.” If we wrote our rights and obligations down for every interaction we have with other people the world would be an unlivable mess. In the case of real estate, the looters made a lot of money off of the assumption that traditional norms would apply–and they clearly didn’t. In this case, the whole mess calls for a do-over–and a do-over isn’t going to be fair to everyone, not by a long shot. On the other hand, if the powers that be keep insisting that real assets are worth more than they are (forcing down mortgage rates, home buyer subsidies, etc.) we’ll never be able to start again.

    Let me put it this way. Should the government subsidize the stock market to support the 401Ks of those who “bought at the wrong time” through “no fault of their own”–after all, the money gets invested periodically while people are working? Of course, there were some sharp operators who used a lot of leverage to make some quick bucks–some got out in time, some didn’t. (Analogous to those who bought in overheated markets because it was time for them to move out of the house/form a family, versus the flippers). Of course not, people would say–houses are different than stocks–there is your traditional norm for you. Stocks are risky, they say; houses aren’t supposed to be.

    I personally couldn’t blame anyone for strategically defaulting–and I think the individual circumstances of each case would tip the scales on whether I considered it morally wrong–i.e., that I wouldn’t trust that person again. But I know why people don’t consider whether they should walk away from margin debt–they don’t have that option. Perhaps in the future the bankers and authorities will remember why leverage is dangerous.

  8. John writes:

    Re: “McArdle favors a world with both easy credit and easy bankruptcy.”

    The problem in my view is that her argument fails to address the fact that mortgage lenders unilaterally, of their own accord, and for their own benefit (or so they thought, anyway) greatly loosened their lending standards during the housing bubble. She wants to hold borrowers to the “norms” of the 1970s despite those clearly not being the norms under which lenders were operating during the past decade.

    My view: lenders made a lot of lousy loans, and it’s going to cost them, as it should. Honestly, I don’t think McArdle has much of a point or any purpose beyond painting herself in what she thinks is a flattering light.

  9. Russ writes:

    There seems to be no end to the hypocrisy of these “libertarians”. Wouldn’t any true libertarian be the very first to say you should walk away if it’s in your best interest? That’s what they preach everywhere else.

    (Oh, I forgot, that only applies to corporations, to the rich, to those who have “property”. That’s the only context where you’re considered to have rights or prerogatives; otherwise you’re an unperson.)

    I guess that’s why it’s all right for Morgan Stanley. And that’s why predatory lending, lending based on obviously absurdly bubbled prices, which the government, the MSM, and the banks themselves colluded to drive up, and the savage behavior of these lenders in the aftermath, bailed out and insolvent all of them, permanent wards of the state all of them, all that’s OK too. (And of course the bailout itself was good moral capitalist practice.)

    But should any individual who’s kicked and beaten by these criminals on a daily basis look to his own interest? His children’s interest?

    No – there, by some unexplained magic, we’re suddenly in a “moral” realm, according to these Hobbesian immoralists.

    Well, I agree, there is a stark morality at work here, and this morality dictates that we owe nothing to a sociopathic system which unilaterally broke the social contract. The banks, the system at large, are enemies of the people.

    We must look only to our own family, friends, and communities, and build upward from there. But everything now “above” us is irremediably rotted, and we owe it to ourselves and our families to get out from under it before it caves in on us.

  10. Indy writes:

    This is a fascinating topic because it is immense – there are so many avenues to go down when one thinks about the nexus between finance and ethics, and so many different ways to answer “what is the right thing to do?”

    Here, I’ll ask a narrow question: if indeed strategic defaults on home mortgages become so commonplace and popular in the aftermath of this crisis that a permanent shift in culture and moral norms occurs and the act becomes completely acceptable (and even considered clever and perfectly proper), then would anything significant happen to the mortgage market? My guess is: No, not much.

    What McArdle (of whom I am also a big fan) is claiming is that the world that will emerge will be a worse one than the one (we assume) we lived in prior to the crash. This is an equivalent statement, in my view, to the notion that in our civil society there is some kind of “optimal” combination of hard-letter law, and prevailing (thought not universally obeyed) ethical tendencies to act in a way more constrained than the minimum required by law.

    So, in the domain of a particular legal relationship, despite there being actions that one party could technically take to personal advantage and without fear of any meaningful legal consequence, that most individuals could still be relied upon to nevertheless restrain themselves and, at the cost of real personal sacrifice, voluntarily forgo these options. They would do so out of their sense of loyalty to a value system that contemplates a set of duties arising out of that category of relationship that are, for some reason, nevertheless not embodied in the law that creates them.

    Now, with respect to debt, there might be a plausible reason for the disparity, for example, religious freedom considerations. Let’s say you have a religious majority that acts consistently with a view that all debt is a near sacred obligation, and one you must honor as long as you are able. There is also a religious or atheistic minority that views debt relationships as being purely business-like, artificial and legally-created entities, the choices concerning which having no real moral dimension. Let’s also assume creditors can’t (or aren’t permitted to) tell the difference between the two types of debtors.

    In this ethically heterogeneous environment, you have three choices:

    1. You could impose the ethical views of the majority by incorporating them into the law, requiring all debt to have full recourse, dischargable only upon a legitimate need for bankruptcy. This would force the minority to go along with a system they would not have necessarily chosen for themselves, depriving them of the option to enter into a non-recourse loan, but which otherwise they still have no moral objection to (since one system of debt regulation would be morally equivalent to another in their eyes). It also yields the benefits of cheaper and easier credit for everyone, as well as an increased price-stability of the market as a whole as compensation. This would be a kind of “individual mandate” for loan terms.

    2. You could have non-recourse, call-option loans for everyone, and allow the non-moralists to painlessly strategically default on their obligations the minute it seems profitable, while still expecting the moralists to generally continue to pay (and to shame and shun those non-moralists, despite the fact they do not, and never did, adhere to those values). There would be “religious freedom” here. The terms of credit would be a little tighter, but the effect would not be evenly felt. For non-moralists, the terms would still be easier than should be expected for a non-recourse loan because they are in effect being subsidized by the moralists.

    For the moralists, terms are harder than they would be for recourse loans – which is the way they are going to treat the loans anyway. What’s worse, since there are now price-risk-immunized participants in the marketplace, price-stability will be seriously degraded, and since price crashes already disproportionally effect the moralists, increased instability hurts them even more. This is a classic free-riding problem.

    Now, in the abstract, why should we consider situation number 2 to be superior to situation number 1? It actually seems quite inferior to me. I think the free-rider problem is a serious one, and what’s more, all else being equal, in these circumstances the honorable cannot compete with the reckless and win when the price of life’s most expensive asset is being so imprudently bid up.

    As an alternative question, is there any reason why should we consider situation number 2 where the non-moralists are a minority, to be superior to situation 2 where the non-moralists are a majority? You would have to do some kind of empirical, data-dependent analysis of net-social-welfare, and it’s by no means clear, a priori, that one is better than the other.

    If there’s no difference, then why should we consider that the gradual shifting of non-moralists from a minority to a majority necessarily makes things worse? Isn’t that what McArdle is claiming?

    Now, of course, I’ve left out the last possibility, the “Libertarian” one:

    3. Let borrowers choose between recourse and non-recourse. Moralists would choose non-recourse and get their cheaper, easier credit with the associated assumption of price-risk and onerous repayment requirements and without the option of backing out later. Non-moralists could choose either option, depending on their appetite for risk and evaluation of the costs. All we’ve done in this scenario is to make an individual’s ethical choices explicit instead of some unknown variable only knowable as some population-statistic. No free-riding problem. No “ethics of default” problem.

    For some reason – this is not apparently a politically feasible alternative in any state. The fact that no state in our democratic society chooses this option is probably very important in this discussion. No state really seems to give individuals complete liberty to define their own debt relationships, and those social judgments matter when talking about the ethics of credit. But at any rate, I think it’s the most attractive option. Would this scenario – where there would be little space left for a zone of ethically-motivated behavior in excess of the requirements of contract law – be any worse situations 1 and 2 above? I think it would be better.

    If it is a better scenario – then the original assumption of there being some optimal combination of law with beyond-the-law behavior is incorrect, at least insofar as mortgages are concerned. The superior scenarios would be for important ethical considerations to be either embodied in the law for everyone, or to be reflected as options among which people can choose in the marketplace, the value of which are reflected in differential prices.

    The Law-and-Economics crowd often point to the solution of these free-riding-problems as a prime raison d’etre of law itself. I don’t see why we should be defending the institutionalization of the problem by advocating a norm of self-restraint and the shunning (but little else) of those the law permits to act in defiance of that norm regardless of the great and unfair cost to the norm-abiding.

  11. JKH writes:


    “Moralists would choose non-recourse”.

    Why? Given the assumption of choice, there must be an assumption of alternative offerings. And creditors will then price non-recourse more expensively than recourse. So why would moralists necessarily choose non-recourse, given the logical introduction of differential pricing?

  12. Indy writes:


    Whoops, typo! My bad. Moralists would choose recourse. Good catch! Thanks.

  13. JKH writes:


    Actually, the moralist could choose either option. It depends how the options are priced and which looks to be better relative value to the moralist. If they’re priced fairly, it’s just a matter of the expected degree of moneyness transferred on exercise versus the price. The moralist may favour “principled” exercise of the option while still wanting to protect the rest of his assets through non recourse, if the price is right.

    The same choice holds for the non moralist. He may favour ruthless exercise in principle, but find the pricing of the non recourse option too expensive for his taste.

    The question is then whether the creditor has some way of identifying moralists versus non moralists, which would allow him to price the resulting matrix of options differently, most importantly for the non recourse cells.

    E.g. if the creditor can’t distinguish, then the common pricing for non recourse will reflect the expected ruthless exercise of the non moralist cohort. This biases relative pricing in the view of the moralist against the non recourse option.

    But if the creditor can distinguish between moralist and non moralist, then pricing for the moralist non-recourse option will be more favourable than for the non moralist non-recourse option, because the non moralist poses a greater probability of exercise. I think pricing for the recourse option would be similar if not the same for the moralist and the non moralist. And both the moralist and non moralist may have reasons for seeing better value in one option versus the other.

  14. Yeti writes:

    > “One group of people who did not violate traditional norms during the course of the credit bubble is the ordinary homebuyer who bought at the top of the market without forming an opinion on valuation,”
    Of yourse they violated traditional norms. Caveat emptor!

  15. Greg writes:

    Great post Steve

    I want to go down a little different road here.

    The Supreme Court is to consider very soon (if they havent already) a case which will decide, for now, where we as a nation stand on the idea of corporations as entities with individual rights. The case revolves around (I think) what level of support business interests can give to influence political campaigns. In the particular case before the court it involves the making of a movie about Hillary Clinton. The question as I understand it is ” Shall corporations be treated as having individual rights”?

    I’m pretty certain how the majority of our court will rule on this, knowing the corporatist leanings of many of these guys, so the question should then be asked; If they have rights of the individuals, should they not have the responsibilities? Or maybe we should turn it around and suggest that maybe we should use corporate “individualism” as a model for individual “individualism”. How ever they rule in regard to corporations we should then “codfiy”, so to speak, this ruling as the template for what we consider acceptable individual conduct with regard to contracts and financial obligations. If they(corporations) want to be able to freely influence elections, make contract/financial decisions solely on the basis of bottom line then so should we, the REAL individuals.

  16. David Pearson writes:

    Great post. I agree that the behavior of mortgage originators is at issue, as is their bail-out by government (something that is just as important).

    There is something else going on, however, and that is leverage. A mortgage assumes that house prices will not fall significantly. What group of consumer borrowers, at any time in history, would agree to walk into a closing and contribute to the bank, in cash, multiples of their annual income? There is no traditional norm that could have stood up to this type of a call on a consumer’s assets. I would argue this is a function of the amount of the call more than it is a function of how unethical behavior changed norms.

    Now, you might respond that it was the unethical behavior that led to a large group of borrowers having little equity. Yes, true for a segment of borrowers, but not the largest segment: prime conforming. These borrowers — the largest group of mortgages outstanding — played by the rules, as did, broadly speaking, their lenders. What changed for them was that they kept extracting equity using traditional products to refinance. Never before have so many conforming borrowers refinanced in such numbers. Is this the fault of unethical lender behavior? I would say its more the fault of the Federal Reserve! Regardless, we are left with a large segment of underwater borrowers where both the borrower and the lender behaved ethically. Why then, are they walking away?

    So I would argue that 4x leverage on a home purchase for large groups of borrowers was always bound to produce an outcome of walk-aways. Think of it as a monte carlo analysis: run enough trials, and you produce outcomes where norms dissolve. The likely hood of these “dissolving norm” outcomes will be most sensitive to the amount of leverage in outstanding mortgages.

  17. [...] UPDATE #2: Steve Waldman [...]

  18. [...] interfluidity » Norms of credit (More on law, societal norms and strategic default) [...]

  19. Greg writes:

    This is just too weird.

    Just after I posted about the Supreme Court ruling I got in my car to go to work,turned on NPR and they were in the middle of a story about the new solicitor general and her arguing the exact case I referenced. The story was about her mostly but they did mention that this was a landmark case deciding some limits of corporate powers.

    What a co-inky-dink

  20. Walt French writes:

    Why in this discussion no mention of BAPCPA, the 2005 shift in bankruptcy law, written to significantly shift rights from borrowers and in favor of consumer lenders (esp, banks) ???

    Banks made this legislation a major goal. Perhaps, thanks to the Law of Unintended Consequences, its passage encouraged banks to make riskier loans, as they felt they were more protected by being able to attach the collateral more quickly.

    A law enacted at the behest of the industry can hardly be said to set social standards that were excessively anti-business. To my knowledge, Ms. McArdle’s tut-tutting can’t provide a shred of evidence that Americans are wholesale breaking the standards set by society.

    In a word, the consequences of filing for bankruptcy suck. People do it when there is no viable recourse. The whole discussion merely masks the fact that the industry — and I’m not hostile to it, merely pointing out the obvious — made a wholesale mess of lending due to trying to crank profits at the fastest possible speed, with the least overhead of credit analysis, and the ability to push most of the loans off their books to securities buyers who were gulled into buying trash with lots of help from compliant investment bankers, appraisers and ratings agencies.

    The US banking system engaged in a pretty-much wholesale rush to lousy standards in its quest for profits. But while individuals have been cleaned out — bankrupted — by their poor judgements about housing prices, our Uncle Sam put feather pillows under the banks’ behinds, and is now trying to prop them up again.

    This entire discussion is utterly misplaced. Our subsidizing fast-buck practices by firms that are in it only for the money is the outrage, not the mostly fabricated notion that individuals are cheating those organizations.

  21. Mr. E writes:

    You have to remember that McArdle argues almost constantly in favor of tough bankruptcy laws.

    She does not favor easy bankruptcy. There must be at least a dozen posts where she comes out in favor of the 2005 bankruptcy laws.

    In other words, she favors easy credit and difficult bankruptcy for flesh and blood humans, but easy bankruptcy, amoral behavior and easy credit for corporations.

  22. Ajay writes:

    Somewhere in here should be included the consideration of the legal notion of “corporate personhood”. The supreme court is probably on the verge of declaring that the US constitution gives the same fundamental rights to corporations as it does to individuals, and that governments have no greater interest in regulating corporate conduct.

    This case (and previous supreme court rulings) is deeply involved with the arguments you make here Steve. Just a thought.

  23. Walking away from your mortgage: Waldman vs. McArdle…

    Megan McArdle and Steve Waldman have been going back and forth about the morality of walking away from underwater mortgages (via Kevin Drum).  McArdle thinks people should keep paying, and Waldman thinks they should walk away. Between the two of them, …

  24. jamie_2002 writes:

    I’ve been following this discussion (and the related discussions on corporate personhood) on a variety of blogs.

    I keep wondering when the fundamental idea of the corporation comes into play as it relates to norms and “personhood”.

    A corporation is a legal device to shield the assets of individuals from the consequences of their actions. An individual’s legal responsibility for the corporations they own is limited to their investment. (See the repeated bankruptcies of real estate developers, for example.)

    A corporation is the way some individuals avoid the moral obligations attached to individuals.

  25. [...] 6) Steve Randy Waldmann: Norms of credit: [...]

  26. Twofish writes:

    From an ethical standpoint I have absolutely no problem with individuals doing “strategic defaults” since if the shoe was on the other foot and you have a financial institution that has an underwater non-recourse loan, it would be about five minutes before they default on it. The only thing that would keep them from doing so is public relations and reputation, and that can easily be dealt with (i.e. sell the loan to a hedge fund made up for anonymous foreign investors). There are so many examples of corporations screwing individuals with strategic defaults, that to make it immoral for individuals to do the same thing seems to wildly unbalance the playing field. (How many union members got their pensions torn up as a result of a bankruptcy?)

    You have to realize that corporate bureaucracies are specifically designed to allow businesses to circumvent a lot of the reputational restrictions. If you talk to a big corporation, then they only person you are likely to be able to reach is some low level customer service representative with zero power, and you have a bureaucratic system that is specifically *designed* so that you can’t pin the blame on any individual.

    Indy: Here, I’ll ask a narrow question: if indeed strategic defaults on home mortgages become so commonplace and popular in the aftermath of this crisis that a permanent shift in culture and moral norms occurs and the act becomes completely acceptable (and even considered clever and perfectly proper), then would anything significant happen to the mortgage market? My guess is: No, not much.

    My guess is that there won’t be many changes and what changes would be good ones. Something that’s important to point out is that homeowners already do something that is similar to “strategic default” which is socially accepted and that is to refinance their loans. When a home owner takes a high interest mortgage and then refinances at a lower mortgage the bank loses *TONS* of money. Also when a homeowner pays off a mortgage so that they can move to another house the bank also loses *TONS* of money in the form of interest payments. What happens is that banks deal with this by hiring lots of computer programmers and modelers that deal with this mess. Adding on strategic default isn’t that big a deal, and it will force banks to pay more attention to the value of their collateral.

    The problem with McArdle is not so much that she has a different vision of the world as it should be, it’s that she has a different vision of the world as it is.

  27. Twofish writes:

    Walt: Why in this discussion no mention of BAPCPA, the 2005 shift in bankruptcy law, written to significantly shift rights from borrowers and in favor of consumer lenders (esp, banks) ???

    Yup. That’s a problem. The problem with a lot of the loans is that the consumers have no real choose *but* to default at some point. If your mortgage payments are high enough and your equity is low enough, then you will never be able to pay off the loan, so it’s probably better for everyone if you default sooner rather than later.

    Pearson: A mortgage assumes that house prices will not fall significantly.

    It doesn’t (or at least it shouldn’t). The reason that the banks force (or should force) you to put a down payment is so that if the house price falls, the homeowner gets hit by that, rather than the depositors to the bank. If you encourage people to highly leverage then you are setting up a row of falling dominoes.

    One other thing is that liability shielding is sometimes a very good thing. If someone starts a risky small business (like a restaurant or a biotech firm), then it’s a very, very good thing that the liability for corporate debt is separate from personal debt. Also people use “liability shielding” on the internet all of the time. I note that most of the people in this thread are using pseudonyms, and what a pseudonym is is an “artificial person” which allows one to separate reputational liability.

  28. Jamey writes:

    Hey, is there anyway that I can incorporate myself and become JameyCorp so at Friedman’s suggestion I can put aside social obligations and look out for my shareholder?

    This reminds me of a news story I heard about the threatened British Airways strike. Customers were complaining about disrupted holiday travel plans and calling the union selfish (I’ll acknowledge that). But what about the management and the customers? Weren’t they behaving selfishly as well? Why is it when management and customers look only to their self interest the magic hand makes everything miraculously work out for the greater good of scciety but workers pursuing their self interest is a threat to the economy and an affront to morality?

  29. [...] Norms of credit Steve Waldman. I’ve been distracted, and managed to miss this important post, which is a must read. I have only one minor quibble, which is this sentence: But that doesn’t absolve a business from its responsibility to craft financial products in a manner that conforms to interpersonal expectations of fair-play. [...]

  30. MM writes:

    First, I completely agree with what Mr. Waldman has written here.
    Second, I think something ominous is happening with people’s reification of things like ‘business,’ and for that matter, ‘government.’ That is, people seem to think of these things as institutions separate from the individuals who use and inhabit them. ‘Business’ can do things individuals shouldn’t be normally allowed to do. But in reality institutions are inhabited, constituted and used by individuals. I realize things are more complicated than this institutions also represent history (the past actions and determinations of individuals) – but this is just more individuals, in the end.

    I think there is an interesting cognitive trick people play on themselves here, and I don’t know it is. Institutions are made up of individuals who use and inhabit them to serve their own interests. But somehow we think that ‘governments’ declare war, or ‘businesses’ act in certain ways, which often serves to remove moral responsibility from the individuals who are in reality just pursuing their own selfish interests under some abstract cover. I am a social scientist, and a number of social science theories also seem to me to get confused about this – thinking of insitutions as abstract objects when much of their reality is in the individuals who use them. I don’t pretend to understand how this all works, but I think it would be worth understanding, so we could evade its bad moral traps.

  31. Greg writes:

    Merry Christmas all!!

    I completely agree with you MM. I’ve always been puzzled by the way we compartmentalize “business”, “government” and “individuals” and ascribe acceptable behavior levels (which seem to be completely different) to each. I’d be a very rich man if I had a dime for each time I heard that governments were evil yet corporations were just doing what they are supposed to do, chasing profit. Each is a collection of individuals and as such are no different than each other, Each individual within that structure has no right to behave according to a different standard just because they are part of some particular group. This is the exact basis of religious strife. I dont have any answers but at least we should be asking these questions.

  32. Blissex writes:

    «There are so many examples of corporations screwing individuals with strategic defaults, that to make it immoral for individuals to do the same thing seems to wildly unbalance the playing field. (How many union members got their pensions torn up as a result of a bankruptcy?)»
    «Why is it when management and customers look only to their self interest the magic hand makes everything miraculously work out for the greater good of scciety but workers pursuing their self interest is a threat to the economy and an affront to morality?»

    But there is a very good reason for many commenters to make a difference: corporations and their management are productive, creative heroes who generate all the wealth; while workers and especially union workers are obviously exploitative parasites who are just out to steal the property of their superiors without producing or creating anything of value.

    In other words corporations and their management are deserving persons, and workers are underserving, at best cattle, at worst vermin.

    If you read Ayn Rand that’s the whole theme: a few superior deserving heroes oppressed by the malignant masses of parasites.

    And if you look at the wealth generated each year by supremely creative and productive individuals like Ken Lay, Stephen Fuld, Jimmy Cayne, Angelo Mozilo and many others, each of them is literally worth thousands of the cattle or vermin in the bottomost 80-90% of the residents, the welfare queens and strapping young bucks.


  33. drscroogemcduck writes:

    For some reason – this is not apparently a politically feasible alternative in any state. The fact that no state in our democratic society chooses this option is probably very important in this discussion. No state really seems to give individuals complete liberty to define their own debt relationships, and those social judgments matter when talking about the ethics of credit. But at any rate, I think it’s the most attractive option. Would this scenario – where there would be little space left for a zone of ethically-motivated behavior in excess of the requirements of contract law – be any worse situations 1 and 2 above? I think it would be better.

    i thought banks could sell non-recourse loans in recourse states. it just so happens that banks/borrowers in these states prefer recourse over non-recourse loans. probably, because adverse selection makes it impossible for non-recourse loans to compete with recourse loans or maybe no-one is willing to pay for the extra risk.

  34. strainer writes:

    I think that because of the huge increase in government borrowing all fiat currencies are going to come into question in the next couple of years, and that’s why I think one of the only safe assets to own is gold. and I just saw another m&a story in the gold mining sector at

    Penmont trumped Goldcorp’s offer for Canplats Resources for the 2nd time in less than a week. With all of the money printing the govt is doing, I think gold will continue to do well, which is gonna lead to more deals like this where the big gold miners acquire the smaller gold explorers

  35. Solicitorodd writes:

    Culture Council,key practical reach these survey exercise warn lot matter branch series fight exchange historical within identify between scientific engineering meet establish finish begin fish consideration channel group fast youth corner create concerned rapidly blow offer cell leading chapter fear convention vital learn something again mouth since station article trip married slow hence chain survive almost would head expression enterprise aim natural only slightly us spirit detailed bridge under confirm remain studio corporate control issue suddenly faith express solution object study cross appear relief nose search building again support spot rare skill

  36. könig writes:

    happy new year – love your blog

  37. pebird writes:

    I think that at times we fail to recognize the degree to which normative rules are consciously exploited into obscure legal contracts. This is doubly-damaging: not only because the individual can be easily misled into an obligation, but more importantly that the normative rule itself is weakened as we learn that manipulation trumps custom. The tragedy is that as personal trust is perverted through anti-social engineering, the expected fallback is the legal system – but as stated above that is a poor substitute and so we are left with a gaping hole in the social fabric.

    I am starting to resist blaming even the “ruthless flipper” for violating inter-personal norms. The ruthless flipper is the one who recognized the reality of the situation, who understood that lenders stopped underwriting and realized that if they acted “morally”, another speculator would receive the funds. The old social norm was that lenders were in a position to understand credit-worthiness and would act as fiduciaries. Now, there is a new “anti-social” norm being promulgated where the borrower accepts greater responsibly, they must have the crystal ball and accept the consequences of an uncertain future. Because we have an inherent desire to perceive a balance (equity), and since creditors have run away from their responsibilities (in fact, we can’t even identify the creditors), we believe debtors must shoulder a greater burden of their own.

    I think homeowners have been very patient, waiting for the state to organize a rational restructuring. I don’t know of any individual who easily accepts the prospect of bankruptcy. Contrast this with business bankruptcy, where there is little stigma and is sometimes even an admired strategy (Trump) to externalize liabilities (asbestos). There are certainly ethical standards for corporations – the very first ethic is that the conduct of the company does not reflect on the individuals running the company (as long as no laws were broken that can be proven in a court of law).

    The financial institutions lost their claim to criticize borrowers when they stopped underwriting and became resellers. The system literally became a market where NO ONE consciously accepted risk – it was something to be sold as rapidly as possible. In such a situation public institutions (pension funds) and individuals were the only entities left to accept the fallout.

    Now that externalities can no longer be deferred, I wonder what it means to be a member of the public? It appears that the public is a sucker – being played for a bit then left with the bill. How can we be surprised when social norms no longer have power – people know the rules have changed, but no one knows what the new rules are. So you are left to make your own. Truly a Randian world, may the most powerful survive.

    In this context, McArdle appears quaint at best, and perhaps a bit naive: a “lot” of the reason for public outrage on the financial industry is that there are no common norms about revolving debt? Seriously? Nothing about public funding of bailouts, the fungible nature of money transforming those bailouts into bonuses, the lobbying for the relaxation of regulations and the restriction of personal bankruptcy?

    Where argument is a little weak, you can always rely on cultural anthropology. McArdle should have issued a home loan in Cambodia to someone who couldn’t afford it, then tried to foreclose and see how different social norms are (I’m sure a queue would form).

    As far as the world becoming worse than it was if people strategically default, I would argue that it will also become worse than it was if they don’t. The power to change the world has not shifted from creditors to debtors – it’s a matter of which worse world we want to live in. Do we want to live in a world of business worship, where “rational” decision-making, private wealth creation, power politics and the advance of the few at the expense of the public are what we value? Perhaps all individuals should incorporate as LLCs to insulate themselves from their own decisions – this is the emerging social norm.

  38. Russ writes:

    pebird says: “I am starting to resist blaming even the “ruthless flipper” for violating inter-personal norms.”

    Yes, as much as I dislike them I stopped including them on the villain list a long time ago. They are very small fry.

    Eyes on the prize means: always blame the big banks and/or the government. Always.

    (Even if I saw a case where it was subjectively true that a flipper had screwed the bank, I’d still blame the bank as a matter of method and principle.)