How to Punish A Bank

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I continue to be unconvinced by the arguments for walking away from a mortgage.  The arguments run in one of several directions:

Companies act like faceless automatons, so we should too.  This is not actually true.  Imagine a bank that actually did only what is specified in their contract with you, and not an inch more.  That would be a bank you'd like a lot less than any existing bank, and with good reason.  They are restrained by various norms, and competitive pressure.  This is not to say that they always behave well.  But they do not, in fact, simply live by the letter of the contract, and if you think they do, I invite you to read me the part in your contract where they have to provide a customer service person who speaks adequate English and doesn't burst into violent profanity when you ask for a mortgage modification.  

Moreover, the way to punish them for behaving badly is either to regulate the bad behavior, or refuse to patronize banks that behave badly, not to simply walk away from your house loan.

Morgan Stanley walked away from its loans.  Really?  Really you want me to be indignant about Morgan Stanley's egregious maltreatment of . . . other financial professionals who saw this coming months ago?  Companies borrow money under different expectations than people do, which is why it's hard for a lot of companies to borrow money, as you'll find if you ever try to start your own business.  The question is B2C and C2B norms, not what businesses do to each other, for the same reasons that I am much more tolerant when stock brokers rip off each other than I am when they do it to their clients.  If anyone else had ripped off the greedy financial professionals, the same people angrily demanding that I condemn Morgan Stanley's actions would probably be cheering.

Banks need to be taught a lesson for their stupid lending  It all sounds very emergent and spontaneous and Hayekian:  a nation of freelance bank regulators.  Every man his own bankruptcy judge!

All well and good, except that if you are walking away from a mortgage simply because the house is underwater, you have no authority to punish them.  After all, the reason it was stupid to lend money to you is not that they were lending money to someone who probably couldn't pay it back; you can.  The reason that it was stupid to lend money to you is that you're a deadbeat--a foolish deadbeat, who thought that house prices are a magic route to free money.  That's not something they could reasonably have been expected to know.  Also, "banks need to be punished for being almost as stupid and greedy as I am" doesn't have much of a ring to it.  

Moreover, those cheerleading such behavior seem to be under the mis-impression that this will somehow be targeted at banks that made stupid loans.  But the people who are walking away simply because the price dropped are not going to distinguish between good, sound credit unions with a conservative loan book, and big, greedy pension funds and charity endowments that bought residential mortgage backed securities.  They're going to walk away from anyone holding the loan on a house where the price has dropped by more than the down payment--which in places like California and Florida, is probably any house purchased between 2004-2007, no matter how conservative the underwriting.

It would actually be a good thing if credit was tighter.  Okay, first of all, nothing would have stopped people from writing awful loans at the height of the bubble, because they didn't think the loans were going to go bad like they did.  Nay, not even outfits like Countrywide, which, last time I looked, were usually required to take back loans that went bad too quickly, since they are presumed to have been fraudulently originated. (This is why so many sub-prime lenders are now out of business, and thus not around to be punished by the Andrew Cuomo wannabes busily walking away from their underwater mortgages).  Contrariwise, no amount of good faith by borrowers could now persuade anyone to offer credit on such easy terms . . . which is why the FHA, which is still willing to write low-down payment loans, is now puffing up like one of those toads that can take a deep breath and instantly grow to three times its actual size.

While it is true that tighter credit would probably be a result of more people walking away from their mortgages, it would certainly not be the only result, nor would it simply mean better underwriting.  A high rate of discretionary default probably means more points and really huge down payments to protect the banks.  Coming up with 25-50% of the purchase price of your house is fine for bankers buying Manhattan co-ops, but a tetchy tricky for most normal people.  It probably also means higher interest rates.  Naturally, this means lower house prices, which means that we can prepare for a rather extended vicious cycle. 

Except that banks would probably flood D.C. and state capitals with lobbyists trying to change the rules.  There hasn't really been much value, up until now, in changing the recourse rules--I mean, banks probably prefer one to the other, but it's not their top priority, because people almost never default on their house unless things are so dire that there's no hope of recovering much anyway.  If that changes, tougher rules become a top priority--and eventually, they'll probably get them, if the alternative is tougher underwriting, higher interest rates, and bigger down payments.

A system that relies on norms against default actually allows us to be very legally and contractually easy on those in need, because most (not all, but most) of the people that we let off will be those in deepest hardship.  We'd be swapping that for a system which punishes them harder in order to deter excessive default rates.

What people want, I think, is simple: to take money from banks and give it to people they like better, ones they consider more deserving.  But while that would be the immediate effect, there's no particular reason to think that the banks would suffer most.  As long as you can't make them lend money, they have the power to share their pain with customers, and as usual, the most vulnerable customers are the ones who will bear the most pain . . . the exact opposite of what is supposed to be accomplished by this.

The bottom line for me is that just because we're angry at banks, doesn't mean that it's okay to do anything and everything to get back at them--much less a good idea.  Our response should be targeted at the things they did wrong (like lending money to people who probably couldn't pay it back), and should cause fewer problems for the general public than it solves.  Voluntary defaults fail on both counts.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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