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July 9, 2010

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A related question: Presumably my mortgage contract specifies that if I don't make payments then my bank will take possession of my house. Suppose that I stop making payments and move out, leaving the bank the keys. Have I walked away from the contract? Or have I honored it, given that the bank's taking possession of the contract was contemplated in the contract itself?

Great question, Dale, and at bottom I think it's a matter of interpretation - is defaulting on your mortgage a legitimate option or a violation of the spirit of the contract? Is repossession simply a consequence of choosing that option or is it a penalty with all the normative implications?

In my opinoin, just because a contract plans for adverse contingies doesn't imply that they're valid alternatives to the contracted behavior, but Holmes and the law-and-economics crowd plainly disagree.

Thanks for your comments, Dale.

There seem to be two issues. First, in setting their loan rates the bank did expect that some percent of their mortgage portfolio would be in default. If in the past declaring bankruptcy was considered socially degrading, people would declare bankruptcy only in the most dire of circumstances when all other options had been explored. The rate the bank charges today thus reflects the embedded moral norms of the past and the bank’s historical experience.

Second, if moral norms change—so that now declaring bankruptcy is simply a minor legal calculation carrying no social stigma—then clearly the default rate would rise. The bank will make a loss on its existing portfolio because it incorrectly predicted that the moral norms of the past would continue.

So the moral quandary is this: is it ethical to make money off of someone (bank shareholders) who extended you the courtesy of assuming you had a strong moral character? That is, they lent you money believing you would carry through to the best of your ability. To me it seems duplicitous to get something that you didn't pay for: had the bank fully understood your moral weaknesses, it would have only lent you the money at a higher rate of interest.

These comments are not a criticism of anyone who has, in fact, walked away from a disastrous housing situation. There are good and acceptable reasons for defaulting. I’m discussing here a subset in which someone can still make payments, but prefers not to. Even in this case I’m not sure I would judge anyone since I have not experienced it myself.

If my mortgage note were held by an elderly aunt who relied on my monthly P&I to live, I would move heaven and earth to pay. But what’s the difference just because the note is held by a corporation? Don’t elderly aunts buy bank stocks? If the bank goes under the government steps in, but don’t elderly aunts pay taxes? There is no free lunch.

Something worries me about that response, Jonathan, but I'm not sure if I can say precisely what. Of course, there is an easy answer here about how the present crisis has perhaps revealed some things about the moral character of bankers such that they are in no position to complain about the moral character of their borrowers. And given some of the lending practices that were in place at the height of the subprime lending frenzy, I'm not sure that it is in fact the case that all mortgages were written based on the assumption that borrowers were of strong moral character. Many of these loans, in fact, seem to have been designed specifically for borrowers with such a weak moral character that they would misrepresent their income. Beyond all of this, though, I think that in setting interest rates banks must taken into account the risk that the world will change in various ways over the life of the mortgage. If they guess wrong, then they lose. If their assumption that I will repay is based upon what moral norms have been in the past, but the norms change and my behavior conforms to the norms as they are now, then I don't know that the bank is entitled to complain that I had some obligation to make the future like the past. I wouldn't think that a bank was wrong to make a profit off of a mortgage holder who felt a stronger obligation to repay than demanded by the norms in place when the loan was written, even though the interest rate was higher due to the laxness of those norms and the bank was therefore benefiting from a conscientiousness in the borrower than it hadn't paid for.

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