January 29, 2010

Analysis of Strategic Defaults (4 of 5)

Filed under: Civil Disobedience, Land Reform, Law — Tags: — Russ @ 3:22 am


Public propaganda, internalized false guilt, and extralegal punitive features of the system outside the mortgage contract collude to produce what Brent White calls “the asymmetry of homeowner and lender norms.” (p.35)
Here’s the basic question:  If it’s an equal contract, then why is the borrower’s obligation to pay somehow considered paramount over the lender’s agreed-upon obligation to take back the property in lieu of payment?
The borrower’s “promise to pay” is held to a moral and social norm very different from the lender’s obligation to take back the house if the borrower walks away. These are equal in the eyes of the law and the market, yet only the lender is considered a purely legal, market actor, and absolved of adherence to any moral or social norm. But the borrower is considered to be fully exposed and answerable to both realms.
The moral and social pressure on the underwater borrower to keep paying for as long as he can is meant to remove from the lender legal responsibility to have the contract executed through his taking back the property when the borrower walks.
This is tremendously unjust. The lender generally has a huge advantage in expertise, knowledge, and understanding of the market and the contract. Clearly it’s the lender’s responsibility far more than the borrower’s to ensure that the terms of the contract are equitable in the first place (especially since appraisals, though paid for by the borrower, are usually arranged by the lender; existentially, “expert” “professionals” are always in cahoots on some level).
All the government and media hype about “responsibility” is especially ironic when we consider how the bubble distorted the market. We described earlier how the normal price-to-rent ratio for responsible homebuying was around 15 to 1 (White p.8 ). So how “responsible” were lenders who were writing mortgages at a national average of 23-1 at the peak of the bubble, reaching 38-1 in the most bloated markets? You want irresponsibility, don’t start with the borrowers, start with the lenders. Of course the bubble is completely the responsibility of the banks, the government, and the media. All this violated the most basic economic precepts. As White comments, “if personal responsibility is the operative value, then lenders who ignored basic economic principles (of which they should have been aware) should bear at least equal responsibility to homeowners for issuing collateralized loans that were far in excess of the intrinsic value of the home.”
Lenders traditionally operated according to a model which showed a strong correlation between loan-to-value ratio and default. So they generally only made loans under conditions where it was unlikely default would become the financially rational course for the borrower.
But as they gathered more data they found that in fact few borrowers are “ruthless” the way the textbooks say (meaning they would quickly walk once they went underwater). So they priced borrower ignorance and moral servility into their models and embarked upon ever more reckless lending, departing ever further from any responsible concept of how well these mortgages could maintain positive equity.
Putting all this together – the asymmetry of expertise and information, the departure of lenders from longstanding prudent practice, and their expectation of preying upon the irrational, emotional mindset of underwater borrowers – we can see how lenders deserve the great bulk of the blame for these bollixed contracts, and should have to shoulder the bulk of the burden. “One might argue, in fact, that the value of personal responsibility would require lenders to own up to their share of the blame, and work with underwater homeowners by voluntarily writing off some of the negative equity.” (pp.37-38) This would be the operation of real responsibility, real morality. But as we know lenders haven’t been called to moral account the way borrowers have.
But what about their economic interest in mods? Surely it’s better for their bottom line to modify these mortgages rather than see them default? But as White found, their models have taken borrower complaisance into account. They’re taking advantage of the very fear and guilt their media campaign seeks to nurture. Since according to their models most underwater borrowers will not default as long as they can make the payments, it’s in fact not in the lenders’ interest to make any real mods.
So directly counter to morality and what would be sound economics in a truly capitalist system, lenders and government have conspired to foist the responsibility and the losses onto the reeling mortgagees.
Here’s the way the “negotiation” often goes. Say a homeowner with a good credit score requests a mod. The lender believes the homeowner will do anything he can to avoid the guilt of default, the shame of foreclosure, and the terror of a damaged credit report. So the lender will say he won’t negotiate until the borrower is 30 days delinquent. If the borrower misses that payment, the lender will then say not till you’re 90 days derelict. After 90 days they’ll say your score is already too impaired for you to qualify for a mod. All the while the borrower is harassed with notices meant to shame and threaten him over his deteriorating status and the dire consequences of complete default.
Throughout the process the lender is playing the odds that the borrower will resume paying rather than face the full impact of foreclosure. Only if the lender really believes the borrower will walk, will he seriously discuss a modification. Only then would it be in his interest.
So we can see why Obama’s modification program has been such a failure. Even if the administration was sincere (doubtful), the lender absolutely does not want to modify. He wants to extract full payments as long as possible. He’s betting on the homeowner’s conformism.
White sums up (p.40):

Most lenders will, in other words, take full advantage of the asymmetry of norms between lender and borrower and will use the threat of damaging the borrower’s credit score to bring the borrower into compliance. Additionally, many lenders will only bargain when the threat of damaging the homeowner’s credit has lost its force and it becomes clear to the lender that foreclosure is imminent absent some accommodation. On a fundamental level, the asymmetry of moral norms for borrowers and market norms for lenders gives lenders an unfair advantage in negotiations related to the enforcement of contractual rights and obligations, including the borrower’s right to exercise the put option. This imbalance is exaggerated by the credit reporting system, which gives lenders the power to threaten borrowers’ human worth and social status by damaging their credit scores – scores that serve as much as grades for moral character as they do for creditworthiness. The result is a predictable imbalance in which individual homeowners have borne a huge and disproportionate burden of the housing collapse.

There’s the basic imbalance. Technically, legally, contractually it ought to be 50-50. In practice the system is heavily rigged in favor of the lender.
In part 5 we’ll look at prescriptions for how to correct this injustice.


  1. […] of making the payments. In my previous series on strategic defaults (part 1, part 2, part 3, part 4, and part 5) I discussed the reasons for this. The system’s actions are predicated on this. […]

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