A recent Volokh post got me thinking. It told the story, now famous from an NPR interview, of a woman who bought a second home in San Francisco with 100% financing. The home ultimately depreciated from $500,000 to $340,000. Even though she admittedly had the means to absorb this loss and keep making payments, she decided that she would just give up the property, not repay the loan, send the keys to the bank, and let them eat the loss. Under a California statute, this was a mandatory “nonrecourse” loan, meaning the bank could not obtain an unsecured judgment after this voluntary foreclosure for any shortfall.
The question is whether this is a perfectly rational and defensible economic decision, or is it instead something wrong, a morally blameworthy failure to keep a promise and take advantage of another because of a statutory right designed for down-on-their-luck homeowners. I believe it’s more the latter. It is bad for the economy and economic growth if people take advantage of bankruptcy and similar statutes without any consequence. This woman is essentially breaking a promise and taking the money that she is not paying back, even though she can easily pay.
It is appropriate that society sanction strategic bankruptcies and foreclosures because, even though it may not make sense to make all of this conduct illegal, it is still wrong and relatively cheap for us to condemn it without employing the legal system. It is doubly important to retain social sanctions for wrong behavior that is lawful, becuase these non-economic motives and tools–including an internal sense of honor, ostracism, and informal punishments in the job and credit market–keep people’s behavior in check, lessening the burden on the legal system and financial markets.
The defenders’ reductionist and “rational” account of the law is itself irrational, minimizing other important functions of the law, and increasing the burdens on the legal system by making the law work against the tide of an increasingly coarsened and selfish society. The law exists, in part, to put teeth in people’s moral instincts. Its legitimacy depends upon providing what appears to be a fair deal. If it does not do so, people disrespect the law and resort to private violence when they feel they are wronged.
The law is an imperfect tool; anyone who has been party to a breached contract knows that “expectation damages” hardly cover the loss in practice, particularly since they do not cover attorney’s fees in most jurisdictions. In the United States, the law worked reasonably well (and cheaply) until recently because there have been social consequences for this kind of behavior to include credit ratings, background checks for jobs, ostracism from polite company and the like. This woman is, after all, being quite shameless about her “rational calculation.” She could only do this in our world, a world where the law ditched most of its vestiges of morality, and then purported to be the arbiter of all that is right and wrong in society.
This is not moralism for its own sake. The economy functions more efficiently if people are bound not just by law but also by a sense of honor, trust, shame, and integrity. In such a world, a more civilized world, fewer deals must go to litigation. There are lower costs for investigating transactions up front and lower policing costs once transactions are underway. This is why economic transactions among extended kinship groups function well. Even without strong legal sanctions, there were strong social sanctions, and these sanctions function well today, as in the past, among merchant peoples like Jewish diamond traders, Greek restaurant owners, and Armenian importers. Without a legal regime, very risky international transactions could be conducted because of the prospect of lifelong social ostracism by tight-knit, business-oriented communities. This positive effect is also apparent in societies, including American communities, that are less diverse and more cohesive. Things run better where a “handshake counts for something” and a “man’s word is his bond.”
By defending this woman, the rationalists are being too clever by half. Their understanding of “economics” is unsophisticated because it ignores the benefits in social costs, the positve externality if you will, of moral opprobrium heaped upon advantage-seeking players like the mortgagor in question. Without some moral outrage here and in other cases of narrowly self-interested behavior, all of us will be forced to impound higher costs at the front end of mortgage and other transactions.
By way of contrast, consider a contract with a liquidated damages provision alongside a normal contract, without such a provision. If both are unsecured obligations, they are undertaken sub speciebankruptcy. That is, any promise can be broken and the unsecured obligation avoided in bankruptcy. But should this be a choice of indifference, done shamelessly, “rationally,” and without regret? I don’t think so. All obligations could be avoided in this fashion at some point in life by strategic “last players,” particularly the retired, the elderly, and those about to leave the country.
Edmund Burke recognized long before the new economists got on the scene that law and government will be more harsh and less effective when it stands alone without social support. He wrote:
On the scheme of this barbarous philosophy, which is the offspring of cold hearts and muddy understandings, and which is as void of solid wisdom as it is destitute of all taste and elegance, laws are to be supported only by their own terrors and by the concern which each individual may find in them from his own private speculations or can spare to them from his own private interests. In the groves of their academy, at the end of every vista, you see nothing but the gallows. Nothing is left which engages the affections on the part of the
commonwealth. On the principles of this mechanic philosophy, our institutions can never be embodied, if I may use the expression, in persons, so as to create in us love, veneration, admiration, or attachment. But that sort of reason which banishes the affections is incapable of filling their place. These public affections, combined with manners, are required sometimes as supplements, sometimes as correctives, always as aids to law.
A free society cannot sustain itself by self-interest and law alone. It requires some public spiritedness and personal honor to function. There are too many situations that both the civil and criminal law cannot easily reach. The free society requires social costs for bad behavior that may be wisely permitted by the law. It’s simply stupid and short-sighted to say, as the economists say, that the law has little to do with morality and also say that morality and the general public should not be so dull and obtuse as to condemn what the law permits in a “business transaction.”
When strategic advantage-taking is manifest, there should be no reason that a respect for “hard headed business judgment” limits our condemnation of someone who is, plain and simple, breaking a promise to obtain personal economic advantage at another’s expense. This is not a situation of electing one of several courses of conduct that qualify as contractual compliance. It’s a breach. The nonrecourse aspect is only a creature of statute. She is using a statutory escape hatch not bargained for by the parties, in fact, a protection little different than bankruptcy protection, that fobs off the costs to future mortgagors.
We are in the midst of a nationwide banking and mortgage crisis that is really a nationwide morality crisis, a perfect storm of lying brokers, lying lendees, short-sighted bank employees, and strategic and dishonest speculators.