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The Morality of Strategic Default

posted by Adam Levitin

Professor Curtis Bridgeman (FSU College of Law) has an article on The Morality of Jingle Mail:  Moral Myths About Strategic Default.  I have a fundamental philosophical disagreement with the article, but it's got a lot of very good, clear analysis of arguments about strategic default, including a very useful typology of argument.  

Professor Bridgeman's article claims not to be a moral case against strategic default.  Instead, he argues (somewhat artificially, I think) that it is merely a critical examination of the claim that strategic default is not morally blameworthy, either because of the borrower's situation, the behavior of the lender, or the put-option nature of the mortgage contract.  

Bridgeman generally presents the arguments for strategic default fairly.  The major exception is when he assumes that the argument for strategic default is that the mortgage contract "gives parties the right to choose between performance and simply forfeiting the house without paying any additional damages." Bridgeman points out that this is hardly true in nonrecourse mortgages, and that most mortgages are technically nonrecourse. I think this overstates the argument. A fairer statement is that the mortgage contract gives parties the right to choose between performance and forfeiting the house and risking paying additional damages. Strategic default on a formally recourse mortgage is about a gamble that the lender won't pursue the deficiency because it's too darn hard to collect unsecured debt. And presumably that's been priced into the mortgage itself and the risk spread over a large pool of loans (contract law consistently fails to internalize underwriting in its analysis because it sees only the individual contract, not the contract ecosystem). 

My major argument with Bridgeman, however, is a philosophical one about what contracts are. He sees contracts as promises. I don't. I see them as economic bargains that have implicit optionality. 

To put this piece in perspective for Credit Slips readers who don't get their kicks out of contract theory, there is a branch of contract law scholarship that waxes philosophical and takes the promissory nature of contracts very seriously. Under this view of contract law, contract is not merely an economic bargain, but it is a moral undertaking, and violation of the contract is therefore a serious failing. This branch of contract theory is at war with what might be called an economic view of contracts, perhaps best represented by Oliver Wendell Holmes, Jr., and his famous dictum, 

“The duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it,—and nothing else.”

Perhaps it's not surprising that few if any true adherents to the contract as moral undertaking view are bankruptcy scholars. Bankruptcy law adds an asterisk to Holmes' famous dictum (from 1897, when there was no bankruptcy law in the US) that a contract is an undertaking to carry out a promised exchange or pay damages. As Professor John Witt has noted, that asterisk say that the damages can be paid in little tiny bankruptcy dollars. But even without bankruptcy, except in the rare case where specific performance is permitted as a remedy, a party to a contract may always choose whether or not to perform or pay damages.  As Holmes observed,

"The only universal consequence of a legally binding promise is, that the law makes the promisor pay damages if the promised event does not come to pass. In every case it leaves him free from interference until the time for fulfilment has gone by, and therefore free to break his contract if he chooses."

Bridgeman presents some rather weak doctrinal arguments in his favor (does the UCC article 2 commentary really carry much weight? It's not the law, and the results under the UCC aren't those that which obtain if contract were promise) that he seems to recognize are not compelling as he couples it with the perfectly fine observation that the legal treatment of an act is distinct from its morality. 

Where Bridgeman loses me, however, is when he next assumes (but never quite comes out and argues directly) that there is any moral content to a mortgage contract. I don't see a compelling case there. I don't see why there's necessarily any more moral content to the mortgage contract than there is to my typing or changing the toner cartridge.

Moreover, contracts can be done be humans as well as by corporate forms, and there is "one law to rule them all." The idea of there being a moral obligation assumed by an LLC is absurd, so why is there one assumed by a sole proprietor who enters the same contract? Or how about a homeowner whose contract is with a bank (a corporation)? Is there only a moral obligation running one way there?

Indeed, can one owe a moral duty to a corporate entity or any other nonsentient object? There might be fiduciary duties, but that's a legal status, not a moral one per se.  (The closest exceptions that come to mind are the Seinfeld episode where Tony the psycho mechanic absconds with Jerry's car because Jerry isn't taking proper care of it or veneration of religious objects, such as doing pennance after dropping a Torah scroll or tefillin, but in both cases, the objects are ascribed anthropomorphic qualities). 

I can't disprove the notion that contracts can never be moral undertakings any more than Bridgeman can prove it. I just don't see any need to go there, and there are plenty of cases where there's no moral quality whatsoever. If banks wanted to ensure specific performance of contracts, they could easily draft them differently--just lend at lower LTVs and force a forfeiture upon default, for example.

But certainly some people see contracts as moral undertakings, and that affects their willingness to strategically default, just as it affects their willingness to file for bankruptcy, and I am not one to deny the deeply held convictions about the morality of contract that these people hold. But I don't think that one can assert there to be a universal morality governing mortgage contracts. It's an optional morality, and I'm not sure what it really gets a person other than locked into a bad bargain and a good sense of self, whatever that's worth. I don't think this is the same kind of morality as "you shall not murder." It's personal, not universal. 

Bridgeman's argument makes me grind my teeth because of my philosophical differences, but I think the article does a really nice job of laying out contract as promise for strategic default, to the point that I'm thinking I might assign it to my contract students next year--it should make for a good classroom discussion. 


"I can't disprove the notion that contracts can never be moral undertakings any more than Bridgeman can prove it."

Perhaps not. But you can propose debtors' prisons for CEOs who lead their corporations to break contracts and either pay damages or file BK, due to those CEOs' obvious moral unsuitability for free society, and see how many Contracts As Moral Statements folks follow you.

Replying to my own comment for something I completely missed...it's not your job to disprove Bridgeman's positive assertion. It's Bridgeman's job to prove it. If as you say he can't prove it, the correct response is "get lost".

Once upon a time, in a world that was dying by the time Dickens and Trollope were writing about it, contracts were moral obligations. Legal economists, with the full support of the business community, hacked away at that philosophy for decades, arguing that contracts were merely business agreements entered into for financial, not moral, reasons. Businesses understandably did not want judges preaching old time religion at them about their business decisions.

Now it's all turned on its head, and businesses are the ones preaching moral obligations. At least for the borrowers. The lenders are arguing they entered into a business obligation to lend the money and a business obligation on how to handle the loan, but the borrower has a moral obligation to repay. Sorry, but contract rights and obligations have to be symmetrical, and business for moral doesn't cut it. Sauce for the goose, people.

If you're going to talk about "morality" in mortgage contracts then you have to have to start out with a balanced contract whereby both parties have similar risk and reward. An unbalanced contract means that the parties are operating at fundamentally different levels of morality.

I have yet to read a mortgage contract that included ANY consequences, save one, for the lender/note holder/servicer etc should any of them breach the contract. Riders appear occasionally whereby if the borrower is required to litigate as a result of malfeasance of the aforementioned, then the borrower is entitled to legal fees and costs associated with said litigation.

Then again, this is "business". Borrowers don't see it as that, though, and therefore are usually ill-equipped to deal with the aspects and attitudes they encounter because. for them, it's not business. In many, many cases it's their very lives. It's "home" for them and their families and never the twain shall meet.

"Strategic default" is perfectly acceptable in business settings. Such as the Mortgage Bankers Association defaulting on their D.C. headquarters to the tune of $79M.

Maybe if there were other, automatic consequences involved with originator/note holder/servicer mortgage contract breaches the contracts would be handled more... professionally or, at the VERY least, equally.

There. is. a. "Rule Book".
EVERYONE plays by the same rules. Or else no one does.

Nice post and I can see what you are saying about the underlying article. I suggest there are multiple perspectives on the issue - three I would add are: 1) in a nonrecourse state, the borrower's optionality has been sanctioned in advance by the law and the lender can be charged with knowing this, supporting the morality of strategic default (to the extent any economic right has a moral component, which is beyond the scope of this comment); 2) similarly, where a borrower invokes the bankruptcy law to obtain a discharge of the unsecured debt, that law was there in advance of the loan and for those borrowers who comply with the legal requirements for discharge, their doing so is equally as moral as case 1 (gaming the system and betting you can just outlast the creditor does not seem to me quite as moral, although its effect is the same - there are lots of acts that produce an identical effect yet are evaluated differently morally); 3) last, financial institutions and corporations are not people, true, but ultimately every economic gain or loss that is accounted for as "the corporation's" passes through to one or more of its constituencies. Which is why people lose jobs and investors lose money when "the corporation" collapses, so I suggest that the corporate nature of the lender is not a bar to a moral analysis of the transaction. Someone gets (or someones get) hurt and, yes, the CEO is probably among them but little of the loss winds up in his or her wallet. I note that point 3 is somewhat at odds with points 1 & 2 but that is life, which is complex.

The problem with Bridgeman's thesis is that he wishes to view the mortgage contract (and the moral imperative) in isolation. This is not the case.

First, where is the morality of creating a $1B pool of money, then chasing possible borrowers for that money? In itself, no issue. But….

Where the "lender" is a system designed to connect intuitional investors with large pools of cash to people who might or might not otherwise borrow money? Maybe still a moral undertaking. But….

Where the transaction is believed on one side to be a simple mortgage, but is known on the other to be a complex financial instrument?

Where the complexity of the transaction has asymmetrical benefits in favor of the "lender" (yield spread premiums, liquidity, ability to create default swaps)?

Where the transaction is in fact a lie? That is, the original mortgage contract being between a named, explicit lender who in fact is not lending anything, is simply acting as a sourcing agent for borrowers? Where the contract (Deed) has a strawman beneficiary whose sole purpose is to by pass long standing chain of title procedures so that the asymmetrical benefits to the "lender" can be realized?

Where the banks have fully acknowledged they did not even follow their own contracts, of their own creation (the PSA) when it comes to the handling of, transferring of mortgages into these complex financial instruments?

And where is the morality of, when the banks, in their hubris, created a house of cards called credit default swaps on collateralized debt obligations - and sought to be "bailed out" by the very same people who borrowed money in this scheme?

I will say for myself, I will hold my head high in my strategic default. For I attempted to by the mortgage (while it was current, never late) from the bank (servicer, originating subsidiary, and the trustee for the MBS) for a price between the HAMP NPV test and an average of 5 BPO's. The bank declined. So now I will stop paying on the mortgage, which is 2x the house value, and does not include the additional loss I had in down payment.

So Mr. Bridgeman? Am I morally corrupt?

To John S,
I would add, what is the morality of flooding the market with money and buyers (artificially) knowing it would markedly increase the purchase price for all, and, furthermore, bribing Congress to strengthen the hand of banks vis-a-vis creditors in bankruptcy law EVEN WHILE YOU ARE INFLATING THE BUBBLE? This is akin to locking the door before setting fire to the house. I'll side with your morality over such an industry any day.

Okay, I'm about halfway through the piece and my patience is wearing thin. About as thin as Professor Bridgeman's logic. He raises and then dismisses many points that should raise red flags all around. Case in point: "To be sure, most lending institutions are more financially sophisticated than are most borrowers, but in this case there is plenty of blame to go around."

Okay, there are two parties of vastly different levels of sophistication, and there is a set amount of blame to be shared between them. But shouldn't we at least attempt to apportion that blame? "Plenty to go around" is a vague concept. I'd like to know how much the borrower gets and what it should cost him or her as a general rule. That might actually be helpful. But Bridgeman is already off onto another topic.

"For whatever it is worth, the most irresponsible institutions continue to pay dearly for their mistakes from the cost of nonstrategic defaults alone."

Do they really? Didn't they get very large handouts of taxpayer money? And how dearly can they be said to be paying when bank bonuses are nearly back at pre-crisis levels?

There is so much in here that leaves a bitter taste in one's mouth: borrowers could "easily" have hired independent appraisers at the height of the market to tell them what a house was worth. True, Prof. Bridgeman, but to what end? With 5 other buyers willing to pay the seller's asking price, why would I spend $500 to learn that it is not worth that? It is if people are willing to pay it.

And later he says that buyers didn't have to buy at all, they could have rented. But this willfully ignores the fact that in desirable neighborhoods there were NO RENTALS at the peak of the market. Moreover, you would also need to address the tax incentives for buying that deliberately skew people in that direction, regardless of price. It really was a conspiracy to induce people to buy regardless of price.

Honestly, Professor Levitan, while I am grateful to you for posting this link and I am a great admirer of yours, I wonder what you are thinking to even consider assigning this essay to your class.

Now I am beginning to question whether Prof. Bridgeman understands anything about how the modern mortgage industry actually works. Here he chides Brent White for arguing that jingle mail is justified because banks have refused real loan mods, when the only sure-fire solution to the current crisis would be for deep principal reductions to deeply underwater loans.

Here is Bridgeman:

"While it might be admirable for banks to modify loans for struggling homeowners, doing so certainly goes well beyond what their promises obligate them to do."

I know what he means by struggling homeowners, but it is not at all clear who he means by "banks" in this sentence. Is it the banks whose name is on the foreclosure document (when it isn't the mythical MERS)? Or does he mean the servicer? Or does he perhaps mean the MBS investor who actually owns the note? Because as most of us know, the interests of these parties are not in the least aligned, and SOME of them would like to give mods whilst others refuse to do so.

From a moral standpoint, the mess I have just outlined seems to strengthen White's case and weaken Bridgeman's. Or am I missing something?

I have a couple of last observations on the objectionable rhetorical devices used in Bridgeman's piece.

Whereas White, in his work, has juxtaposed everyday contracts (i.e. with cell phone carriers) with the mortgage contract in an attempt to minimize the weight of breaking such a contract, Bridgeman consistently (and shamefully, IMO) maximizes the weight of this "promise." He compares breaking such a promise to theft, murder, and unprovoked physical attacks.

Furthermore, he repeatedly puts "widows and orphans" on the other end of the (potentially broken) "promise" to heighten the sense of moral wrongdoing. Thus institutional investors in MBS are never, in his examples, hedge funds, investment banks, sovereign wealth funds, or TBTF banks, but always pensioners and mutual fund holders. By defaulting, in other words, you are taking money away from your own mother and father. Shame!

I am frankly outraged by the way Prof. Bridgeman tries to intimidate defenders of strategic default, implying that they could be guilty of inducing breach of contract. He is careful to point out that White probably does not do this, but he is clearly trying to draw a line in the sand and scare others from joining his cause.

Reading this article as a non-lawyer, I can't help but focus on the ways in which lawyers like Bridgeman give themselves (and their clients) ways out of the moral dilemmas that we, mere mortals, must face on our own, unshielded. Thus there is nothing immoral about a person setting up an LLC, borrowing money to buy a property, then defaulting on the mortgage when the loan goes upside-down. Why? Because that little contract insulates the person, silly! See, no immorality on me!

Bridgeman ultimately seems to believe that a wave of strategic defaults would undermine the fabric of American civilization and render us ungovernable barbarians. He presumes that there exists an intact social contract, under which we all live and prosper. But I don't think that is true anymore. I think that social contract has been torn up by an elite that includes TBTF banks, a collusive political system, and toadies like Bridgeman who cover their tracks. TARP and every "reform" that has come after have been a massive cover up, and nothing has been fixed. If more people take White's advice and walk away, the system will crack up, and the truth will be shown. What's so moral about extend and pretend and mark to fantasy accounting?

Nothing, nothing at all.

I couldn't agree w you more. I find Bridgeman's invocation of "widows and orphans" particularly objectionable. The facts are that the top 1% of the population owns 51% of all financial assets and the top 10% of the population owns 90%. So there aren't many "widows and orphans" being injured by strategic defaults; at least not many needy ones.

Contracts are business agreements. If a person chooses to not meet the agreement it's a business decision. Corporations have no problem breaking contracts when it increases profit...cry me a river.

I'm not a lawyer, but I've had to deeply consider the severe negative equity situation due to the nature of my business. I remember reading Dr. White's excellent "Underwater and Not Walking Away" paper August of last year and have been revisiting this topic a number of times since then.

I think I have something to add to the discussion, and I'd be very interested in feedback.

I believe a case can be made that there are moral components to a contract (any contract), but in an area I don't see emphasized very often.

In the beginning, I think it is evident there is some obligation for each party to make a good faith effort to perform to the contract.

What I find interesting is that the definition of what constitutes "good faith effort" in this situation lies entirely with the performing agent. The other party, and society at large may have a (possibly different) opinion about what is best effort, but it is the acting agent that must make the final determination and then act or withhold action.

I personally have a hard time assigning moral value to someone's internal "good faith effort" metric since I have no way of knowing what issues they are facing, and even less visibility into what they value.

Notice that just before the agent determines they have passed beyond what is the limit of their good faith effort, there is no default, and there can be no penalty, only the contemplation and weighing of potential penalties against the costs of performing.

Once either party determines they might not be able to justify performing their contractual obligations -- that it may be more advantageous to breach the contract and deal with the penalties -- the contract has become unsupportable to that party.

This is a continuum that extends from the most petty justification for breach up through situations where the penalties are orders of magnitude less than the cost of continuing to perform and even into situations where the party has no physical ability to perform what is required by the contract regardless of penalty.

As an aside, it seems hard for me to follow any argument that a mortgage $200K underwater, or requiring a family to forgo then next 5 years of their ability to build any equity at all and leaving their family utterly exposed to even the slightest financial disruption is within a good faith level of expected performance. $200K is serious money for any individual. Five years is a significant and unrecoverable fraction of a family's entire financial life.

I would argue that in this situation, both parties have a moral obligation to try and renegotiate a mutually agreeable compromise.

I think the evidence that an actual *moral* obligation exists, begins with the observation that no legal requirement exists.

Yet... There remains some ineffable impelling force that the parties should come together to explore a mutually agreeable solution to the problem. It doesn't rise to the level of compelling the parties to cooperate. But, I would ask the reader to consider an unsupportable contract they have known in the past to see if they don't sense even a whisper of an internal voice that the two parties should at least discuss the alternatives.

I believe this impelling force that can be sensed is the very moral obligation that exists between parties to a contract.

They don't have a moral obligation to find a compromise. Many times, no mutually agreeable compromise exists. But, I argue this is a real, moral obligation for the parties to work together in good faith to find a better arrangement for both parties.

Now, if the parties cannot find a compromise for any reason, even simply choosing not to participate at all in the discussion, the moral obligation is extinguished.

At that point, the parties should each be expected to maximize their self interests individually with whatever means the contract and the controlling law allow.

The reader imagining the moment a contract renegotiation falls apart may feel that sense of a cord bringing the parties to the table falling away or being cut. I believe that is the feeling of the moral obligation of the contract terminating, the sense that the relationship between the parties is now in a very different place. I would argue further that this internally sensed change betrays the existence of the supra-legal ineffable connection I noted before, the moral obligation of contracts.

Once a contract becomes unsupportable, and either party decides there is no acceptable compromise, all of the requirements for moral agency is extinguished. At that point, as many many respondents have noted, the contact is purely "just business."

Moral Agency in Strategic Default

I find the analysis of agency in a strategic default very illuminating. Happy to develop it if there is interest, but the digest version is this: A homeowner that entered a mortgage they can afford and then serviced it perfectly (both are a condition of strategic default), has done nothing to create their negative equity situation. When this borrower approaches the bank to renegotiate the loan, they are refused which extinguishes all moral considerations (as discussed above). The borrower has no agency in this unilateral termination of the discussion.

After that, both parties are simply pursuing value maximizing, moral agnostic paths.[1]

The homeowner has no moral agency in the decision to foreclose, and the most responsible party (the lender) has the balance.

The banks setup the environment for the U.S. housing crash through speculation, and then they become the active agent driving the market down by forcing distressed sales from homeowners unable to negotiate a better outcome.

Mark Moore, CEO
HomeLiberty, Inc.

[1] This also explains the behavior of lenders making hypocritical/indefensible morality pleas to induce underwater borrowers to stay in irrational contracts: the lenders are simply maximizing their value, and the pleas are effective. Hypocrisy is not illegal, so the banks should be expected to do everything within their power to maximize their expected returns.

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