Strategic Defaulters Are Not Mortgage ‘Deadbeats’
Bloomberg News’ Caroline Baum has a tart piece on strategic defaults and consumer spending — invoking the theory, first put forward by HousingWire’s Paul Jackson, that underwater homeowners are purposefully defaulting on their mortgages and using the funds to buy regular goods. That would explain why consumer spending is increasing despite high unemployment, declining real incomes and rising foreclosure rates. Historically, at least, cash-strapped consumers cut their discretionary spending and then stopped paying their auto loans and credit cards before quitting their mortgages. But the latest recession has upended that calculus. And homeowners left owing more on their homes than their homes are worth are more and more often walking away.
Baum writes, “Those deadbeat homeowners, facing possible eviction and in some cases unemployed, are throwing caution to the wind — and money at retailers.” I quibble with that depiction. Strategic defaulters are not “deadbeat,” nor are they lacking “caution.” They are making an economically rational calculation, generally one that is in their best interests. They walk away, and the bank takes their house — that is how real-estate contracts work, and banks themselves do it all the time.
As Roger Lowenstein wrote in the New York Times Magazine: “Mortgage holders do sign a promissory note, which is a promise to pay. But the contract explicitly details the penalty for nonpayment — surrender of the property. [When a homeowner strategically defaults, he] isn’t escaping the consequences; he is suffering them.”
Moreover, strategic defaulters tend to be economically distressed. These “deadbeats” decide that they and their families would be better off finding a new place to live, rather than continuing to let their mortgage winnow away at their income. My guess is that they aren’t heading out to buy new Hummers, but rather thinking more along the lines of toothpaste and new shoes and infant formula.
Baum also questions whether the math works. She writes:
A mortgage lender or bank experiences reduced cash flow, which means less money flowing to shareholders who, the last time I checked, were consumers in their own right. Sure, one can argue that the borrower has a greater propensity to consume than the lender, but this is a case of what Lawler calls “single-entry analysis for double-entry bookkeeping” and what I view as an example of Bastiat’s broken window.
This makes no sense. When a consumer strategically defaults, she reaps the benefits of the boost in income immediately. The relationship between banks’ cash flows and shareholder payouts is, on the other hand, obviously non-immediate and highly complex. The bank waits to classify payments as late, then the house as in default, then as a foreclosure. It takes a while for the foreclosure to happen. Then the bank often waits to put the property back on the market. Then it takes some time for the bank to sell it, sometimes for profit, sometimes for a loss. Banks do this on the scale of hundreds of thousands. And every once in a while they determine how much to give their shareholders in dividends. There is no magical transaction by which a single default nicks a penny from every shareholder at the end of the quarter. But the theory that homeowners are strategically defaulting in high enough numbers to free up consumer spending seems rational to me.