Policy Court

Opinion of the court, delivered by David Lamb, signed by William Leich
If you have ever been to an airport, contracted a computer virus, or taken a look at the Social Security system, you know that security often isn’t secure.  And even though Wall Street bankers call subprime mortgages “securitized,” they know that the difference between “securitization” and securitization is a matter of bears and bulls—and not the type found in the zoo.

The subprime mortgage crisis that became the financial crisis that became the recession that became the Great Recession wasn’t a consequence of market failure or misguided risk-taking.  Rather it was the result of individuals—bankers and homeowners—behaving like individuals at the expense of the broader economy: exploiting bankruptcy laws that mitigated their own risk, not by removing it, but by imposing it on third-parties.

Subprime mortgages are called “secure” because their loan value is designed not to exceed the value of the property.  This means that if a homeowner becomes delinquent on a mortgage, the lending party can foreclose on the home and recover the loan’s entire value.  As long as real estate prices are static, banks don’t carry significant risk writing mortgages without down payments.

The problem is that this system depends on home values not falling below mortgage values.  When they do—when delinquent borrowers owe more than their houses were worth—creditors can be stuck with a deficit: their collateral—the house—is worth less than their credit—the mortgage—which means foreclosure doesn’t bring all of their money back.

Non-recourse loans, which protect borrowers and compose the majority of American mortgages, compound the problem.  These loans stipulate that debtors whose houses have been foreclosed on have no responsibility to pay the remainder of the mortgage if one exists.  In other words, if the value of Mike’s house drops enough that his mortgage is larger than his home’s value and he stops paying his mortgage, his bank can foreclose on his him, but can’t seize his car or his television.

By defaulting on his mortgage and walking away, Mike earns money.  By continuing to pay the mortgage, Mike overpays for his house.

As the last eighteen months have shown, the bank isn’t the real loser in this arrangement.  After all, the bank can declare Chapter 7 bankruptcy protection and its debts become an externality forced on its creditors—the largest of which is often the federal government, attempting to avoid bankruptcy among large financial firms by loaning them money.

Banks realized that bankruptcy was a possibility, and, knowing that bankruptcy laws had them covered, made a calculated decision to trade risk for return.

In finance, risk is directly related to profit—the riskier the borrower, the higher the demanded interest rate.  The more risks a firm is willing to take, the more it can earn.  Because bankruptcy protection shelters irresponsible risk-taking, banks have an opportunity to take more of it.

Limited liability laws mean employees and owners of defaulting companies can’t be pursued by the companies’ creditors.  Thus when payment bonuses are structurally related to immediate profit, financial managers can accept excessive gambles, earn excessive payouts, and, worst-case scenario, lose their jobs when their gambling leads their employers into failure.  The more likely situation seems to be that the Federal Reserve saves the companies and most managers’ jobs with them.

Consider, too, that there’s something in this for borrowers.  If Mike, in an alternate scenario, has no mortgage and is having trouble selling his house, he may be able to find a bank that overvalues it and offers him a non-recourse mortgage with a five percent down payment.  Once he signs the mortgage he can ditch the property and walk away with the money.  That the bank can’t recover the value of the mortgage by selling the house isn’t Mike’s liability.

And yet it could unhinge the economy or necessitate a taxpayer-funded bailout.  If Congress wants to avoid future bailouts, it needs to reform bankruptcy laws so that they don’t allow for individuals to profit from risks that were forced upon the entire economy.  Otherwise bankers and homeowners will continue to abuse the spread between personal risk and economic dangers.

Indeed, if individuals behaved with macro-economic outcomes in mind, recessions wouldn’t exist; Americans wouldn’t have overspent when they should have been saving and wouldn’t be saving now, when they ought to be spending.  However individuals largely look to individual outcomes, and these outcomes have awoken the bears on Wall Street, and it’s the taxpayers who are being mauled.  It’s open season.

Nicole Adams, Concurring in part, dissenting in part:
The moral hazard argument set forth in the opinion—that if Mike finds himself upside-down on his non-recourse mortgage he will declare bankruptcy—is flawed.

Aside from social stigma, bankruptcy comes with a number of costs that the opinion doesn’t account for—among them that it bars the declarer from receiving credit in the future.  Given credit’s importance in the American lifestyle, from the bridge loans that lubricate month-to-month business to personal mortgages to credit cards, losing credit is a massive cost.  And not one that Mike, or another rational American, would endure to avoid overpaying by a few thousand dollars for his house.

Still, the issue of businesses balancing risk with return is real, and our bankruptcy laws and limited liability laws help alleviate the personal risks of reckless financial behavior, encouraging finance workers to pursue return even if that means putting the health of the economy in jeopardy.

As the opinion states, the Federal Reserve ought to allow large banks to fail.  That creates job risk for their employees.  Congress ought to limit chapter eleven bankruptcy protection, so as to avoid companies exploiting it as a convenient restructuring technique made necessary by bad decisions.

Non-recourse mortgages, however, need to stay.  Particularly in current times, where homeowners are, as the opinion warns, getting mauled by the bears of real estate meltdown, the government can’t take away their clothes.