Why Shouldn't People Just Default?

James Surowiecki has a column this week on strategic default that implies that we should end the double standard on strategic default which lets corporations walk away from unprofitable real estate, while borrowers get off scott free.

I think there are a number of weaknesses in the argument, starting with the example he leads with: the American Airlines bankruptcy.  It's true that American chose the timing of of their bankruptcy, but as I understand it, they were deciding when to walk away, not whether.  The company has lost money for four years running, and while they had $4 billion in the bank, that doesn't mean they were $4 billion away from insolvency--a company needs working capital, especially if they're in a seasonal business.  American had a working capital deficit that has grown substantially over the last four years.  They were not nearly as healthy as "$4 billion in cash" makes them sound (GM had considerably more than that when they went to the government for a bailout), and the bankruptcy was not the strategic decision to stiff the unions that I think Surowiecki implies.  It's absolutely true that the net effect will be to rewrite union contracts in ways that the unions don't like--but as I understand it, it's also absolutely true that if the contracts aren't rewritten, a bankruptcy in which they will be rewritten anyway is a very likely outcome.  It's not obvious to me that American Airlines has a moral obligation to keep operating for the purposes of transferring extra money from their creditors and suppliers to their pilots.

As well, doing it early allowed them to go through bankruptcy without securing debtor-in-possession financing, which saves some costs and ups recovery rates for everyone.

There's also the fact, which he doesn't really deal with, that commercial loans are offered on considerably less attractive terms than residential mortgages, precisely in order to counteract default risk.  Surowiecki says that strategic defaults "would force lenders to be more responsible in the future" but he doesn't make it clear that the corollary is "people would find it harder to get a mortgage (and the value of homes would drop)".

But tighter lending standards are far from the only way that commercial mortgage lenders protect themselves against the possibility of default.  Most commercial real estate loans are for much shorter terms: with the exception of some commercial multifamily mortgages, the terms are 7-10 on the high side, and 3-5 is more common.  

They do not amortize significantly, meaning that the principal amount must be repaid or refinanced at the end of the term.  (This is how residential mortgages used to work too, until the Great Depression triggered wave after wave of foreclosures when people suddenly couldn't roll their notes.)  Imagine if you had to go to roll your house note every five years--say, right after you'd lost a job.

The allowable Loan-to-Value ratios are also much lower--I'm told 60-75% is the most you can get in normal times, though during the bubble, as with residential mortgages, you did (more rarely) see 100% LTVs.  And lenders demand the right to an extensive prowl around your financials for the last 5 years--not only intrusive, but it raises the fees associated with getting the loan.

Did I mention that the interest rates are also substantially higher?

The "people don't default unless they have to" norm allows us all to get much cheaper loans, while letting off those who, well, really have to.  Destroying that norm would come at considerable cost: 25-40% minimum downpayments, higher foreclosure risk, higher interest rates, higher fees.

Felix Salmon also points out that this would have the slight side effect of further trashing the housing market and leading to more foreclosures--and that a world in which everyone thinks about their house as a sort of strategic investment is not necessarily a very health one, economically or emotionally.

I don't think there is something particularly strange about saying that humans should act differently from businesses, and that separate ethical codes might apply to them.  (I feel perfectly comfortable prying into the inner workings of corporations in ways that I would be reluctant to do to my neighbors, however interesting that might be; for some reason, the squeamishness about different standards only runs one way.)  

Especially in cases like this, where the ultimate losers aren't really "big corporations" but "other people who didn't default".  Even if you don't think people have an obligation to Bank of America, you might think they have an obligation to the people down the street.