Strategic default and the duty to shareholders

Megan McArdle thinks strategic default by underwater homeowners is not okay:

I am afraid that I am one of those people who have no patience for people who refuse to pay their debts… There is a sizable school of thought that says why shouldn’t they? They made a contract with the bank under known rules, and as long as they’re willing to pay the penalties, why shouldn’t they just walk away, the way a corporation would? Well, for one thing, companies don’t always behave like this, and those who get a reputation for stiffing their suppliers run into trouble. But for another, because society doesn’t really work on such clean logic. The reason we can have easy bankruptcy and a pretty robust credit market (usually) is that most people act like debts are obligations which should always be paid off if possible.

I would like to agree with her. I think that if we structured the economy so that I could agree with her, we’d have both a better world and a more prosperous economy.

But, in the world as it is, in this mess as we’ve made it, her position is beyond unfair. Businesses walk away from contracts all the time, whenever the benefits of doing so exceed the costs under the terms by which they are bound. McArdle is certainly right to point out that companies frequently honor costly bargains they could get away with breaking, because their reputations would be harmed by walking away. But, reputational costs are economic costs. They are a part of the cost/benefit analysis that firms use in making decisions. It is not virtue that binds them to keep their word, but medium-term self-interest. Similarly, homeowners consider the hit to their credit rating and potential loss of social standing prior to walking away.

The question is whether debtors should keep paying off loans simply because it is the “right thing to do”, even when, taking all financial and non-financial costs into account, they would be better off reneging. A human being can choose to be “upright” in this way, if she wants. But under the prevailing norms of business, managers of all but the smallest firms can not so choose. To do so would be unethical.

Let’s recall Milton Friedman’s famous essay, The Social Responsibility of Business is to Increase its Profits:

In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers… Of course, the corporate executive is also a person in his own right. As a person, he may have many other responsibilities that he recognizes or assumes voluntarily… He may feel impelled by these responsibilities to devote part of his income to causes he regards as worthy… spending his own money or time or energy, [but] not the money of his employers… [T]o say that the corporate executive has a “social responsibility” in his capacity as businessman…must mean that he is to act in some way that is not in the interest of his employers…spending someone else’s money for a general social interest… Insofar as his actions…reduce returns to stockholders, he is spending their money. Insofar as his actions raise the price to customers, he is spending the customers’ money. Insofar as his actions lower the wages of some employees, he is spending their money. [H]e is in effect imposing taxes, on the one hand, and deciding how the tax proceeds shall be spent, on the other… [He] is…simultaneously legislator, executive and jurist.

In 1970 when Milton Friedman published these words, I think they must have seemed a bit radical and weird. But today this view is triumphant, both in theory and in practice. Mainstream theory and law view a corporation as a “nexus of contracts” between consenting individuals. Firm managers are agents, employed to act in the interest of shareholders. Shareholders are imagined to unanimously share a single goal — maximizing financial value. When a manager acts in a manner inconsistent with that overriding goal, for motives virtuous or vile, she is imposing “agency costs” on her employers, expropriating resources which are not hers. She is behaving unethically.

An individual, on the other hand, is not so conflicted. Her resources are her own. If she acts against her interest, she harms only herself, and most of us agree that there are times that virtue demands she do so (though we’ve no consensus on just when). McArdle can argue that individuals should pay obligations they’d be better off shirking, in the name of a larger, social good. But under the now prevailing view, she can’t ask that of businesses, because that choice is not firm managers’ to make. If managers or some shareholders wish that a costly action be taken in the name of social responsibility, Friedman helpfully reminds us that they “could separately spend their own money on the particular action if they wished to do so.”

In practical terms, exhortations to individuals that cannot apply to firms leave us with what Felix Salmon aptly describes as “the world’s largest guilt trip“:

The result is a system tilted enormously in favor of institutional lenders who exist in a world of morality-free contracts, and who conspire to lay the world’s largest-ever guilt trip on any borrower who might think about joining them in that world. It’s asymmetrical, it’s unfair… no one would expect a capitalist company to behave in the way that individuals are being told to behave…

Individuals must operate in a competitive economic environment dominated by entities constitutionally incapable of overriding self-interest to “do the right thing”. Virtuous individuals can expect no reciprocity from the firms with which they contract. They have two choices: live nobly and get screwed, or adopt the amoral norms of their counterparties. It has taken some time, but we are all coming around to the only supportable view. “It’s just business,” we shrug, even if we never wanted to be businessmen.

At this moment, the amorality of the transactional, profit-maximizing firm has seeped into most of our commercial relationships. This contributed grievously to the financial crisis: employees of Wall Street firms do not view themselves as morally bound to the fate of their employers, but as atoms negotiating the best terms that they can for themselves. When they found themselves able to enter into arrangements that offered irrevocable cash payments against uncertain accounting profits, they did so eagerly. When flippers discovered they could borrow huge sums of non-recourse money for real estate, and capture huge gains with little personal wealth at risk, they did that too. Asking flippers not to put back underwater property is precisely analogous to asking Wall Street whizzes to give back their exorbitant pre-crisis earnings. The latter won’t happen, so the former should not. Given where we are, every underwater homeowner should absolutely act ruthlessly in her self-interest. If that leads to further turmoil and collapse at the banks, so be it. I see no reason why deeply flawed institutions should be sustained on the backs of the virtuous, via a kind of stupidity tax.

It didn’t have to be this way, and going forward, perhaps we can find a way out. As I said at the start of this essay, I’d prefer to live in a world where I could agree with Ms. McArdle. It was not inevitable that we conceive of the firm as a nexus of contracts without agency for moral action except via implausible relegatation to shareholders. That is just one of many possible ideologies, and a rather idiotic one. The core notion that shareholders “own” the firms they fund is, in my view, a poor definitional choice.

But so long as the “social responsibility of business is to increase its profits”, the social responsibility of customers is to look to their own self interest. Even if that means dropping their house keys in the mail and renting the place next door.


38 Responses to “Strategic default and the duty to shareholders”

  1. […] Interfluidity: Strategic default and the duty to shareholders Megan McArdle thinks strategic default by underwater homeowners is not okay: I am afraid that I am one of those people who have no patience for people who refuse to pay their debts… There is a sizable school of thought that says why shouldn’t they? They made a contract with the bank under known rules, and as long as they’re willing to pay the penalties, why shouldn’t they just walk away, the way a corporation would? Well, for one thing, companies don’t always behave like this, and those who get a reputation for stiffing their suppliers run into trouble. But for another, because society doesn’t really work on such clean logic. The reason we can have easy bankruptcy and a pretty robust credit market (usually) is that most people act like debts are obligations which should always be paid off if possible. […]

  2. […] contracts like that, but does the individual responsibility of morality prohibit some from leaving?Close Forward this […]

  3. A big issue is that these consumers were so often deceived. The mortgage broker, real estate agent, etc. made it look like these purchases were so much safer, and so much of a better deal than they actually were. So many of these consumers are walking away from agreements that they never knowingly agreed to, and never would have knowingly agreed to.

    It would be a different story if these people honestly knew what they were agreeing to, if the risks were not misrepresented, or kept unknown to them.

    In addition, even if a person, or family, clearly and fully knows the risk of a purchase, or loan, or any investment, any risk, and they still decide to take that risk, we’re far better off as a society, we will have far greater total societal utility, if we have some risk pooling, some social insurance, so people can much more often sensibly take risks that have very high expected returns, but are still risky. This is why the founding fathers put a provision for bankruptcy right in the constitution.

    An every man for himself, Meagan McArdle, extreme libertarian world, is a far more risky, far less productive, incredibly lower utility world, and that’s not even counting the devastation of productivity from free rider problems, inability to patent practically, other and massive externalities, massive monopolies, and on and on.

  4. Real Estate writes:

    The Board of Directors represents all shareholders. Real Estate

  5. Indy writes:

    This is an issue I’ve been thinking about for over a year now. I recently returned to my Law / Economics student life from a deployment to Afghanistan with an Army Military Intelligence unit. Prior to the deployment, several of the other officers had been stationed at the height of the housing bubble at facilities located near D.C. in Northern Virginia. They lived in very modest homes which were removed from their workplaces by substantial driving distances, but these homes were nevertheless particularly pricey for someone with a family and on a military salary. The humble homes ate significant chunks out of those salaries as the commutes did to the (already scarce) time these men had to spend with their families.

    Such are among the many sacrifices of military life even in peacetime. There are, it seems, a multitude of wealthy lawyers inhabiting the good neighborhoods in the concentric circles of significance around the capitol. There is real irony is how their biding up of the prices of real estate in order to achieve influence over power has muscled out the very men who are entrusted by the nation to wield it.

    Despite the high prices that dominated before the crash, when my friends had reported to their new posts they found the local branches of the nation’s largest bank chains exceedingly eager to “serve” them. The companies offered to loan them (well, “originate”) up to 100% of the asking price plus costs with a minimum of fuss, delay, paperwork, or any other prudent diligence. I had a similar, “Really, is that it? That can’t be right. Are you sure that’s all you need?” experience when I received my mortgage in 2005 from Countrywide. Those were the days.

    The officers were also heavily encouraged to dabble in those now infamous Option-ARMs and other dangerous financial “innovations”. The temptation must have been intense, but the men were skeptical, conservative types, and they opted for traditional fixed-rate mortgages. The Army is a place where an officer is busy with planning half of the time and busy ignoring those plans the other half because all one can do is a kind of ad hoc improvisation and adaptation to constantly changing circumstances. In few other places will one learn more about the limits, almost futility, of planning for an unknowable future full of unforeseeable and defined by unintended consequences. The Army depends and thrives on the bravery of the Soldiers and the caution of their superiors. “Safety” is akin to an ideology and a way of life. Likewise, these were brave and safe men who chose safe mortgages that were “safe as houses”.

    While we were away, about halfway through our deployment, the crash began and something mysterious had gone horribly wrong with the machinery of America. The small equity positions these men has invested in their respective residences were wiped out in a matter of months. By the time they were close to returning to these homes the men were all badly underwater by over one hundred thousand dollars and, what was worse, the Army had reassigned them. They would be required to move promptly upon redeployment. They were simply not in a position to hold out, wait for prices to go back up in the long term, and continue making monthly payments. Unfortunate professional timing had compelled them to buy at the top and sell at the “bottom”. Wasn’t the avoidance of precisely this “fire sale” scenario the purported rationale for the bailouts of the financial institutions? But no extension for families, it seemed.

    So, as the depth of the murky trouble in which they were finding themselves became increasingly clear they all found themselves perplexed as to what to do. Their uncertainty had two dimensions – (1) technical and (2) moral. They asked for my assistance and I tried to explain the little information I had learned about short-sales, negotiated settlements, and other ways of dealing with their banks to offload their properties and debt obligations (Virginia is non-recourse). I explained what I knew about what the various consequences – for example to their credit scores – would likely be.

    When they were presented with these various options one course of action usually stood out as an obvious winner when measured purely in terms of their financial self-interest. However, they still wondered which fork in the road was the right one ethically. They had each accumulated a small life’s savings over the course of their careers, and they could decide to hand over the entire family education and retirement fund to the bank or choose one of the legal options that would let them try and keep it. What was the right thing to do? Were their wives and children the “shareholders” of the family, the welfare (to include the financial well-being) of which the preservation constituted the highest ethical goal?

    With these men, and with many others I would estimate, they sense a moral dimension that should be addressed in their decision-making but they don’t know how to conduct the ethical analysis. They look for guidance and advice in the words of their acquaintances and the acts of their community and national leaders.

    Their instinct was that if they had borrowed money from a friend or a neighbor they would feel a deep, almost sacred, obligation to make good on their debt and pay it off in full plus interest as soon as they could manage it. It would be wrong to stiff the guy next door even if you were in trouble and the law would let you get away with it. Their first impulse was to extend the principle to all debts, including the one on their house. That was, after all, the “right thing to do” as they had been taught by their parents and grandparents.

    But then the bailouts with taxpayer money started. The “too big to fail” talk began, and then the wave of foreclosures and layoffs and emerging scandals of the unjust excesses of the financial industry, and so on. And these men began to feel that from the personal scale of their little world, their family was also perhaps “too big to fail” by the forfeit of their hard-won life’s savings.

    They also started to question how the bailouts could make sense without some of the benefits flowing to innocent and responsible men such as themselves. They all knew some reckless nut next door who lied on his applications and bought six houses to “flip”, each of which more than double what he could conceivably afford. How could this crazy man be permitted to just abandon ship and mail the keys to the banks? And what about all the people who were getting the “shadow bailout” by “strategically defaulting” and purposefully living rent-free until the day of eviction, sometimes a year later? How is it just that these frauds would be the primary beneficiary of the foreclosure delay acts of the state legislatures? All of sudden, what had seemed moral now appeared foolish, even stupid.

    And then it never seemed to end – bailouts for the car makers, countless earmarks, and a thousand inexplicable giveaways in the “stimulus”. And these gentlemen are not economists or political scientists and must distill the message of these actions through our hysterical and hyperbolic press which tells these stories in a way so as to make us terrified and irate.

    And the point of all of this is that even the meekest law of real estate finance can have a profound effect on our cultural values. The whole moral universe, in regards to debt, has been overthrown for these good and righteous men with whom I went to war. They started out with an inclination as to what the right thing to do was, and then they were unsure. Then they questioned whether they were just being “suckers” and if there really was any kind of moral question at all given what was happening in the world around them.

    I wonder what new moral lessons these men, indeed our whole generation, will now teach our children and grandchildren. I’ll guess that the content of these lessons will not include much sense of moral obligation or sympathy towards banks. Perhaps that’s for the best, moral intuitions being supportive of certain beneficial survival instincts in the modern dog-eat-dog financial world where ordinary folks need be constantly on their guard. I hope it doesn’t spillover, baby-with-the-bath-water-like, and create a generational animosity for a free market economy and open society in general. I also hope they find a way to preserve some space for social interactions involving money that aren’t “just business” and where, indeed, it’s sometimes worthwhile to make an non-mandatory personal sacrifice for no other reason than because its the “right thing to do”.

  6. vlade writes:

    Company is a society construct. It cannot exist without society to support it. If the benefit to the society is less than the cost, the company gets done for. Note that this is following exactly the same amoral logic (amoral != bad by definition). So, the problem is to define the cost to the society, in the other way the externality costs that the company is not carrying right now. Companies will, by definition, try to externalise as much as possible (it maximizes shareholder gain) – in limitus by enslaving everyone who is not a company shareholder (thus creating an absolute maximum gain to the shareholders).
    From the perspective of the society, there needs to be something that forces them to internalise the costs. We should focus on figuring good ways how to internalise the costs (BTW, even hard free-marketers recognize that externalities exists, and are one of the things that do distort perfect markets). We know when it’s easy to externalise the costs – for example when the industry is concentrated and when it’s easy for the industry to lobby those in power.
    I doubt that regulation will help much, as the regulation is ultimately another human/societal artefact and thus subject to lobbying by the companies + the agency problem of those in power (or, as Mr. Soros would say, it suffers from reflectivity).
    The only way I see forward is to institute other principals, whose aims are opposing and have comparable power (overall). Easier said than done – alhtough your suggestion falls into this category.

  7. q writes:

    i don’t understand the terms of this discussion. what is a “strategic default” for a corporation?

    if a corporation “refuses” to pay its debts (ie it has the cash flows to do so but does not), the holders of that debt have the right to force the company into bankruptcy. if the assets are there, the debtholders will get them through bankruptcy, and if not, they will get ownership of the business or claim to the proceeds of liquidation. so why would owners of a business do such a thing?

    just as an aside, a friend of mine is contemplating a “strategic default” right now. he owns two jacksonville fl condos which are worth no more than half what he paid for them. one was funded via a short term no money down mortgage; there is no way he can refinance this, so he will default at some point. because he has negative cash flows from this property, the incentives are to default sooner than later. and because this is going to screw his credit for the next seven years, there is essentially no penalty for defaulting on the second mortgage at the same time. i don’t know what he is going to do, but i know what makes the most sense economically.

  8. q writes:

    oh, i’ll just add one thing here.

    the person who took out these two loans is an old friend of mine. he is an extremely dependable person, works hard, etc., and buys into a materialist/consumerist ethic — someone who under normal circumstances makes for a very good credit risk. he made a stupid mistake; he got carried away with market mania etc in 2006.

    i’d bet there are a lot of people like him who will be underserved by the banking community over the next few years, and, what i’m saying is, yes, there is money to be made extending credit to these people.

  9. […] Should underwater homeowners “strategically default”?  (Interfluidity) […]

  10. Guillaume writes:

    Indy has posted a fantastic comment.

    vlade: immoral = bad, amoral is neither moral or immoral.

  11. vlade writes:

    @Guillaume: I know, I was just defining my terms :) – the logic of “maximize returns” is IMO amoral, as it could be “maximize the wellbeing of community” or “maximize the pain I inflict”. So it depends on what you want to maximize whether the result is moral or not – but the policy is neutral.

  12. IdahoSpud writes:

    I see that Morgan Stanley has “strategically defaulted” on five office buildings in San Francisco. I would hope Megan McArdle has the same disdain for a company that she has for individuals that look after their own interests.

  13. Interfluidity, you have completely misread Friedman. You are confusing “social responsibility” with “ethical responsibility”. If a business signs a contract promising to repay a loan, it has an ethical responsibility to repay the loan. Here’s what Milton Friedman said about ethics (which you conveniently omitted):

    “In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to their basic rules of the society, both those embodied in law and those embodied in ethical custom.

    The ethical custom of American society is to repay our debts. The money is the property of the lender. The lender lends its property to the borrower for temporary use. If the borrower does not return the property, it is not that much different than theft. It doesn’t matter whether the borrower is an individual or a business, it has an ethical responsibility to repay its debts as long as it has the ability.

  14. Steve Randy Waldman writes:

    Bubble Meter Blog — I am very aware of Friedman’s caveats. He uses the ideas like “ethical custom” and “deceptive” to describe situations where companies are ethically bound to act against their interest.

    But those caveats, when they are not reinforced by legal judgments, are so slippery as to be meaningless.

    With respect to debt, we are talking about debt that explicitly or implicitly under the terms of the legal jurisdiction governing the contract is non-recourse. Is it deceptive, then, to take advantage of its non-recourseness?

    An example that Friedman frequently used is pollution control. If a company can legally pollute without consequence, he was very specific in claiming that for managers to impose costly controls at the expense of firm stakeholders is “taxation without representation”. Yet many kinds of pollution pretty clearly and directly create costs for others, sometimes even very severe costs. Is that in accord with “ethical custom”? It’s a judgment call, and one in which the competitive and pecuniary incentives are all on one side.

    Let’s take a recent case. Executives of health insurers were called before Congress to testify about rescission. They were asked by a grandstanding Senator whether they would agree there and then to cease rescinding contracts except in cases where there was evidence of intentional fraud. They said no, that’s not how the State laws that govern them are written. I don’t recall for sure if they said they had a duty to shareholders. They certainly and without any sense of irony appealed to the welfare of customers (as Friedman does), in the requirement to keep premiums low. Is recission of a sick individual’s insurance contract based on an application misstatement not intentionally fraudulent a violation of “ethical custom”? The phrase is meaningless in such a technical situation: customs can only really be established for common and widely understood practices. Is it deceptive? I think so. But wouldn’t a health care CEO who unilaterally made that judgment and imposed poorer returns on shareholders basically be overriding the judgment of the polity, which Friedman points out has appropriate checks and balances which a corporate exec does not? Wouldn’t such a CEO still be subject to the practicality constraint that Friedman underlines, that relying on firm executives to enforce social responsibility is impractical, as they’ll be fired by those they “tax”?

    Friedman’s argument is devastatingly solid, given the conceptualization of a business organization he begins with. If you start with his axioms, you end at his conclusions, and you end at them with a force that demolishes Friedman’s weak and pleasant sounding caveats.

    Oh, and it is certainly not the “ethical custom” for businesses in the United States to pay off non-recourse obligations because of some ethical duty to the lender. Besides real estate examples, of which there are plenty, US firms frequently let subsidiaries they wholly control go into bankruptcy rather than paying off creditors. In fact it is common practice and US firms are masters at the art of designing “bankruptcy remote” subsidiary entities precisely to synthesize non-recourse borrowing for ventures the exposure to whose risk they wish to limit. Lenders are supposed to monitor their exposure to risk, but that is their responsibility when they lend nonrecourse to homeowners as well. (And banks who lend to homeowners are fully aware of the limits of recourse in the jurisdictions in which they make loan. Housing lenders are much more aware of these implicit contractual terms than homeowners typically are, so banks can hardly claim to have been “deceived”.)

  15. Indy writes:

    I tend to think of it like this:

    RECOURSE LOAN: Equity or Deficiency (if negative) = Fair Market Value – Remaining Debt. (So, it can be positive or negative)

    NON RECOURSE LOAN: Equity = Value of Call Option priced at Remaining Debt. (It can’t go below zero).

    When states pick between the two – and banks choose to operate in such environment – then society is definitely making a clear choice about the ethical custom and norm of how to distribute risk and reward with regard to price fluctuations of leveraged purchases of real property. I happen to live in a recourse state – the norm here is you better pay back your debts if you can afford to.

    But in other states, things are obviously different. The only way it could be clearer and more explicit would be if mortgagors were also granted a Put Option priced at Remaining Debt (a debt discharge repurchase agreement / basically a deed-in-lieu-of-foreclosure). Maybe such an absolute right to walk away is the next step in the struggle to permanently reestablish sound underwriting principles.

  16. SW:
    I have no problem with individuals defaulting. Goldman Sachs (GSG) can get bailed out by Zimbabwe Ben (ZB) when AIG was about to go bankrupt and leave GSG with a $13 billion problem. Of course Blankfein and Viniar deny this. Let the banksters rot. Why should Joe Schmoe work to “ratify” CDOs and such that GSG peddled? Storm the Bastille! Off with Blankfein’s head! Citigroup gets bailed out by ZB’s suppressing interest rates and Joe Schmoe should pay his mortgage! Why?

  17. Realty-Based Lawyer writes:

    Not true that, legally, corporations can only maximize profits for their shareholders (however fictive a notion that may seem in view of the percentage of profits claimed by Wall Street for the employees). Corporations are allowed to donate to charity. Long ago, such donations were made by Henry Ford and challenged by his shareholders; if I remember correctly, Ford won. Don’t have time to look up the case or research Delaware law on similar issues, but I think that expenses *not formally approved by shareholders* or *even by the Board of Directors* that don’t directly contribute to the bottom line are OK under corporate law – *iff* they’re approved/directed by management, who is given great discretion. So management could practice virtue – if it wanted to….

  18. Steve Randy Waldman writes:

    Realty-Based Lawyer — I hope I didn’t leave the impression that under the status quo it is illegal for firms to forego profit for virtue. It is not. Managers have very wide discretion in anything colorably classifiable as business judgment, and since there are economically valuable reputational benefits to “socially responsible” behavior, courts are likely to grant managers the benefit of the doubt. I did not mean to suggest that shareholder lawsuits were any kind of constraint on corporate action. They may be, but they are strange and capricious beasts whose contours I don’t pretend to understand.

    My claim, just recapitulating Friedman, is that under the predominant norms of business (which are Friedman’s), it is both unethical and impractical for managers to sacrifice wealth to social responsibility unless the costs are outweighed by some kind of private benefit. It’s unethical, if managers are mere agents, because it’s not what their principals wish them to do. (Under simplifying assumptions, shareholders unanimously prefer wealth maximization, since they can satisfy idiosyncratic wishes privately.) It’s impractical, because managers who give more to charity than reputational benefits justify will get sacked by shareholders.

    You are absolutely right that no legal restraint prevents costly virtue by firms, unless the action is so costly that it falls outside a very broad realm of reasonable business judgment. “Social responsibility” is not illegal. But as we’ve defined things, managers ought not sacrifice wealth altruisitically, because it is taxing Peter to pay Paul without due process. And they are largely constrained from doing so if they wish to keep their jobs.

  19. […] Commenter “Indy” offered the following in response to the previous post on strategic default by underwater homeowners. I think it’s worth a read: […]

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  22. Mr. E writes:

    It has come to the point where some people cannot bear to live in the world whos creation they stridently advocate.

  23. If the contracts are the products of fraud (as many of them were), then even under law of contract, they are unenforceable.
    From the broader perspective, Steve is right: for the rule of law to have any kind of legitimacy, it must ultimately be predicated on some basic rules of natural law, one key principle of which is fairness. The reason why the Swedish bank restructurings worked reasonably well in the 1990s is because there was a general sense of shared sacrifice throughout the population. We don’t have that today. We have a state dominated by corporate predation and nobody is holding the banks, health insurance companies to the same kinds of standards as the home owner or credit card debtor. It is the purpose of government to align incentives with broader public purpose. Obama has failed comprehensively here and he is now reaping the consequences of his initial actions in office.

  24. Anym_Avey writes:

    The missing link in your effort to analogize business and individual behavior is that businesses are regulated more heavily and, when publicly owned, their records are likewise made public. If individuals have the right to meet business and industry on identical terms, then the other shoe will drop with equal force. Let us send the government to your doorstep and audit your home for ADA compliance — that ought to be a howler. Maybe OSHA can show up and identify some handrails and safety harnesses you are missing. You cleaned out your garage and moved heavy things without an approved workman’s corset, hardhat, and high-visibility vest? Yeah, that one is going to cost you. Does your kitchen and dining room meet appropriate food service design and sanitation requirements? No? Also, why aren’t you wearing appropriate footwear at all times, seeing as how food service is present on the premises? Not done yet, though. Let’s take a look at all of your financial records for the past several years and then publish the results. Better get started on that 10k filing and supporting documentation, I hear they’re kind of a bear to fill out, and you’re going to be required to sign them under fear of both the IRS and the SEC. If they could pin four felony counts to Martha Stewart, your innocent mistake ought to be good for at least one or two.

    Or, maybe we can continue to recognize that we have, by design, somewhat different standards for public businesses and private individuals, and that things continue to work best that way.

    Note that this is not a defense of irresponsible behavior by business and industry, only that the ordinary machinations of business and industry are not an equal standard for analyzing how individuals ought to conduct their affairs, even when interacting with said business and industry.

  25. atmos energy bill payment…

    Megan McArdle thinks strategic default by underwater homeowners is not okay:I am afraid that I am on […]…

  26. Mr. E writes:

    I think people that are advocating moral behavior are really missing the point. We are creating a world where economics dominates, and economics is dominated by rational actors.

    Steve is correctly pointing out that you cannot have both sides of the argument. If you don’t like individual people and families strategically defaulting, then you cannot accept that corporations must act exclusively in their self interest. But if you think that corporations should act exclusively in their self-interest, then you must accept strategic default by actual flesh and blood humans.

    You don’t get to set different standards for rationally self-interested parties because one is alive and the other is not.

    Hate to make the thread go astray, but the SEC was prosecuting Martha Stewart at the very height of Bernie Madoff’s multi-billion dollar fraud. It is a bit weird to see all these

  27. movertyperguy writes:

    McCardle’s motives aren’t pure.

    She’s in the market for a home loan, and she’s admitted that her desire for underwater homeowners to slit their own economic throats is driven by her appreciation of the fact that if those homeowners make rational economic decisions for themselves and their families, then Megan McCardle might have to pay a higher interest rate on her home loan when she enters the market.

    So, it’s not too hard to figure out Megan McCardle’s game. She wants to enjoy a low-interest home loan on the backs of broken families throughout the nation. She wants to “guilt” them into making stupid financial decisions for themselves because she’s greedy and wants the lowest possible interest rate for herself.

    She should be ashamed to show her face in public.

  28. Scott Wood writes:

    “Asking flippers not to put back underwater property is precisely analogous to asking Wall Street whizzes to give back their exorbitant pre-crisis earnings. The latter won’t happen, so the former should not. ”

    Not “precisely” analogous. The “Wall Street whizzes” had employment agreements which included being paid based on the most recent year’s performance. Not next year’s performance. Last year’s performance. You can argue that it wasn’t a wise decision for the company’s to offer employment on such terms, and maybe you’re right. But those were the terms, and the companies were merely fulfilling them.

    The strategic defaulters, OTOH, are actually reneging on their agreements.

    Personally, I think Megan is spot on on the general principle of the extreme importance of trust in the economy (and you are grotesquely misunderstanding Friedman), although I kind of think that not defaulting on a debt that will require you to live in extremely reduced circumstances, including probably not being able to save anything for retirement, for the rest of your life is a bit punitive. Accepting the ancillary costs of reneging on your mortgage in the situation she cited doesn’t strike me as terribly unreasonable.

    movertyperguy: And the lowest possible interest rate for everyone who might want to buy houses in the future. Your morality seems curiously backward-looking.

  29. movertyperguy writes:

    “I think that if we structured the economy so that I could agree with her, we’d have both a better world …”

    Here’s the world we live in: The value of a home isn’t decided by the homeonwer. It’s a made up number. Who makes up that number and who benefits by that number?

    It’s decided by the bank at loan time. And there is a nexus between the government and the real estate industry that demands that the home buyer be forced to purchase at the highest possible inflated price that person will pay. The benefits that accrue to government under this scenario are so great that the government has no incentive to protect consumers from fraud committed by the banks and appraisers.

    The real estate industry consists primarily of:

    * banks
    * realtors
    * appraisers
    * lawyers
    * insurers

    They all benefit massively when home values are inflated, and this is the most important point: at this point in our history none of these institutions care if the loan is repaid.

    The bank doesn’t care. They will resell the loan to the government the moment it closes (to Fannie and Freddie, who underwrite the process).

    It is not 1950. Back in the 1950’s banks cared about repayment. Glass-Stegall was repealed, however.

    Banks no longer make money on the repayment of mortgages. They no longer assume those risks; so it is no longer in their interests for banks to ensure repayment. Banks make money on loan origination and fees – not long-term interest repayment (the rates of return of which are at historic lows set by the federal government).

    Realtors make money on the price of the house – 6%, usually split between two realty companies. Their interest is the inflation of the home price.

    Appraisers want banks to hire them. Banks want high loan amounts (more profit on points)… thus a nexus formed between the bank, the appraisers and the Realtors to artificially inflate home prices – to commit a fraud against the buyers.

    The state governments benefited from this – so they didn’t stop it. They loved it as they rolled around in newly found property taxes on inflated made-up home values. Look at where Stimulus funds are going if you really want to see what’s occurring. Most Stimulus funding worked its way to state governments, then down to local governments to replace property taxes that dried up when home values evaporated.

    Banks were permitted to loan money even to people not in the country legally. And guess what: they still are today.

    So now, … the music has stopped. Now, here comes Megan McCardle to guilt us that we should repay our home loans because “it’s the right thing to do.” She completely ignores the massive fraud that has occurred and who committed the fraud in the first place: banks and appraisers and realtors and the government fraudulently conspired to inflate the home price to start with.

    Now they want us to hold the bag; and the government that enabled it all is handing our tax dollars to their co-conspirators.

    Every institution in society, including our government, is now arrayed against us homeowners at the time of purchase. They all conspire to set the highest possible price on the home. They all benefit. We do not.

    Then, when the music stops, Megan wants to guilt the hapless home purchaser?

    Fk that.

    You’re a moron if you continue paying an underwater house note in our current society.

  30. ethan salto writes:

    I’m not sure I would assign McMegan such a personal, material motive, but it is true that she hero-worships corporate and financial elites and can’t abide the notion that the “deep social infrastructure” of our country has been more harmed by their behavior over the past decade than some jerkoff who got a bad mortgage and walked.

    It’s weird to be in partial agreement with movertyperguy, who I’ve had an antagonistic relationship with previously.

  31. Chris of Stumptown writes:


    The money is NOT the property of the lender. NOBODY repays the same dollar bills they borrowed. In fact they never received any property of at all, merely accounting entries.

    What I wanted to say is that Megan “Jane Galt” McArdle is being quite selective in her Objectivism. Naturally John Galt would ruthlessly default. Rational selfishness and all. Agreed with one of the posters that there is some cognitave dissonance going on with McArdle.

  32. umair writes:

    killer post.

    “so long as the “social responsibility of business is to increase its profits”, the social responsibility of customers is to look to their own self interest”

    captures perfectly the bad equilibrium hardwired into our institutions.

  33. Walt French writes:

    I might agree a whole lot more with the absolutist “corporations EXIST only to make profits” if there were no bankruptcy for corporations. I.e, your $200 to Delaware buys you the right to put your debts to other citizens, while they enjoy none of the upside from this right. It’s absolutely unconscionable that we give well-off shareholders the right to extract quick buck profits, hide the bad news with opaque accounting, and then put the shell of what’s left into the public’s hands.

    Akerlof and Romer wrote an insightful paper called “Looting…” about the practice. Of course, the limited liability corporation wouldn’t have any reason to exist without the protection from bankruptcy reaching thru to shareholders, but it seems only recently have we so totally corrupted the intent.

    Investment banks were mostly partnerships up until a few years ago, and they could be again. Alternatively, we could require every financial corporation to have risk-based insurance to cover their bankruptcy costs.

  34. […] 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 […]

  35. Jason Paez writes:

    Steve, I think you’re right on the money with this post. Elizabeth Warren has a fondness for exploding toasters which I think is very relevant here, and I even blogged this in my response to you on my own site (

    She’s says (this is from 2007:

    “It is impossible to buy a toaster that has a one-in-five chance of bursting into flames and burning down your house. But it is possible to refinance an existing home with a mortgage that has the same one-in-five chance of putting the family out on the street–and the mortgage won’t even carry a disclosure of that fact to the homeowner. Similarly, it’s impossible to change the price on a toaster once it has been purchased. But long after the papers have been signed, it is possible to triple the price of the credit used to finance the purchase of that appliance, even if the customer meets all the credit terms, in full and on time.”

    Even Ben Bernanke bought an ARM that “exploded” and had to be refinanced, which he admits in his Time Magazine interview for person of the year. He had a good job and good credit to fall back on of course, otherwise he’d have faced the exact same decision scenario you describe so well here.

    Jason Paez
    The Polifinancial Times: Debating a New Financial Order

  36. Jamey writes:

    This debate brings to mind an experiment I heard about where a daycare center introduced a fine for parents who picked up their children late. What they found was introducing the fine actually increased the number of times parents arrived late to pick up their children. Prior to the institution of the fine the parents felt a sense of moral obligation to pick up their children on time and felt guilty if they failed to do so. After the institution of the fine, they viewed it merely as a fee to be paid if they chose to be late. Actually, it was only a fine from the daycare’s point of view since fine implies a punsihment for failure to live up to an ethical obligation, while conceiving of it as a fee removes the matter from the realm of morality completely. McCardle here is viewing the loan in terms of moral obligation where foreclosure is the “punishment” for failing to live up to an obligation which one should feel ashamed of doing if they are able to meet that obligation but fail to do so. The strategic default view just looks at foreclosure and the hit to your credit record as a price to be paid and opted for if economically rational.

    The problem with viewing this in moral terms is that lots of these subprime loans were inherently immoral in the first place. It’s a little late in the game to be introducing ideas about fair play above and beyond what is legally required when basic social norms of fairness would have dictated that loans under these terms not be issued in the first place.

  37. chris g writes:


    I do not like the way you glorified a soldier’s position in society to cover up for their unbridled greed.

    From day 1 the soldier knows the soldier’s life. He knows he can be moved and deployed. Rarely do soldiers get to stay in the same place for a long time. For a soldier to buy a house without a margin of safety, i.e. being able to rent it, being able to hold it if the market turned south, etc. he must have been trading on greed, fear or something other than his conservatism that you so poetically allude. A conservative soldier would have bought a house in which his payment would have been lower than the rental value. If he couldn’t find such a house, then he’d rent, knowing that being moved on a moment’s notice is exactly what he signed up for when he volunteered to be a soldier.

    I know what was going through their heads. The same thing that went through everyone’s heads… prices had been going up. The money was there. That’s all they needed. The fact is that they made a worse mistake than other people because they knew they had mobile careers. Greed needs to be punished, not covered and excused with patriotic excuses.

  38. […] Details below the fold.Bad Economics: If 25% of households are underwater right now, it would be foolish to assume that those people would or should stay in their house. (Steve Randy Waldman made this point a while back.) […]