Why people should be ALLOWED to act like corporations, and why libertarians should not try to stop them.

Megan McArdle has returned to the subject of recourse, the ability to sue for debt after the security is returned, in mortgages.

"mortgages were issued under a tacit understanding that people do try very hard to pay their mortgages, even when it's hard.

And changing those mores would be expensive--not for banks, but for homeowners."

This portion of her article forms a question that should be possible to test economically, and if not, then it raises real questions about the viability and desirability of economically rationalized governmental policy.

Economists normally say that economic failures, as in the case of the Soviet Union, have a rational basis, more scientific in nature than a simple matter of misbehavior, or "sin". If social mores can truly overwhelm large economic incentives for decades at a time, then this throws a lot of economics, and the Western governmental policy built on economic ideas into question. If non-recourse mortgages are likely to actually produce notably worse mortgage terms, then there should be clear evidence of that between the US states which have recourse mortgages, and those which do not.

The history of the US would also seem to cast some doubt on the idea that social mores are so strong that they preclude sharp practice in contracts and deals. The "Yankee peddler" and horse trader were famed for their cunning back in the colonial period, just as the used car dealer is today, and it is not only professional sharp practice which has a long and well established history. The very earliest US government housing program, created with the Homestead Act saw ordinary Americans pushing the limits of legality not only to the limit, but often past it, with straw buyers and other dishonest tactics being commonly used to allow people to claim extra land.

So if economic incentives should produce differences in mortgage terms to the disadvantage of the inhabitants of non-recourse states, and if such differences are not in fact apparent, then why not? I think that several factors are likely to be decisive.

1.

As a practical matter, banks cannot generally go about making home mortgage loans where the loan is commonly for a sum notably larger than the value of the property. If the bank can't get most of their money back between previous payments and foreclosure, then this means either a catastrophic loss of value due to an overwhelming economic depression, or that the banks were inflating a real estate bubble, in contradiction of sensible business practice.

2.

Individual mortgage holders are not in fact likely to be able to benefit by allowing the bank to foreclose on their property. It isn't that difficult to see why this would be the case given the notable black mark on one's credit history, and given the fact that the payments that one makes on a normal mortgage cover not only interest, but capital, and these payments cannot be reclaimed in foreclosure. Tack on transaction costs, and it is obvious that this is not a good means of exploiting a bank under normal circumstances.

3.

Onerous documentation requirements on home mortgages do not make practical sense for one of the big reasons that business income taxes are not as economically efficient as personal income taxes. A commentator that McArdle quotes lists some of this sort of documentation.

The borrower had to give the lender a statement of cash flow and net worth every quarter?
The property value had to be above a minimum loan-to-value ratio?
The borrower had to maintain an income at some multiple of the monthly loan payment?
The borrower had to maintain a minimum net worth?
The borrower could not make significant changes to the property without lender consent?
Everything had to be personally guaranteed?

The simple fact of the matter is that businesses, and their income, losses and expenses are generally much more complicated than household incomes and budgets, and the economics of a business are likely to vary a lot more than the economics of a household.

Now having stated why I do not think that recourse mortgages are economically necessary, there is the question of where a libertarian, or to be frank even a simple capitalist should stand on the matter. There are two big reasons that I think that people who are libertarian, or who simply believe in capitalism should support non-recourse mortgages.

1.

It is not in the best interests of banks, much less the economy, for banks to be supporting real estate booms premised on false valuations. This doesn't really change whether or not mortgages are recourse, or non-recourse.

Just as things which are bad for an individual in the long run can seem tempting however, the policies which can harm an institution like a bank can seem tempting for a time. Recourse mortgages help to obscure the need for banks to ensure that mortgages are based on sound valuation. A loan officer could imagine that the actual value of a property is not really important, because the buyer can be chased down. This is not likely to be a sound practice, and it is unlikely to pay off, but the temptation is enhanced.

2.

Recourse mortgages are in practical terms, a much less market-based mechanism for loans in the housing market. Most housing foreclosures are not going to be driven by the calculating real-estate speculation of people trying to game the market.

For the majority of foreclosures, where the house buyer cannot afford to pay, making the buyer pay off the entire debt to the best of their ability is likely to involve fairly elaborate calculations of the buyer's ability to pay, by a government official. Just how much debt a person can afford to repay is not a strictly scientific calculation, and the arbitrary aspect of such calculations, encourages additional government intervention in the market, and additional government intervention in incomes.

3.

Recourse mortgages have the potential to create situations where a person is in substantial debt for something which they do not have. If the bank takes away a person's house, but a person is in debt for years or decades to pay for the house that they do not possess, this situation is, in the main, going to be regarded as being unfair by most of the public. The simple dynamic of paying for something that the bank has taken away is so simple a narrative that even when the home buyer behaved irresponsibly, the story will arouse sympathy with the buyer, and anger at the banking system and capitalism in general. A libertarian ideology is advocating minimal government intervention, and to succeed, such government intervention as takes place must seem as simple and as fair as possible.

A look at the counter-capitalist ideologies of today, and going back through the 20'th century is going to show that the great question has always been, do we rely on economics and non-governmental action to obtain what people need, or do we rely on values, mores, and the government. Economists have held that the market and voluntary transactions can fill more holes than many ideologies would claim. The question is, whether the same is true for mortgages, or are mores and detailed and elaborate government enforcement actions needed to hold down mortgage rates. Do you believe in the market?

Regarding Foreclosure Options

Megan McArdle has been commenting on foreclosure and she has made some excellent points, like "the perils of jingle mail", which is to say that returning a house does not, in many states, remove your obligation to pay for it.


With her article"Foreclosure Options" however, she turns to the desirability and ethics of recourse (a mortgage holder can sue you for debt after foreclosing on your property) versus non-recourse mortgages, and comes down heavily on the side of recourse mortgages, particularly in a moral sense.

But another question occurred to me. "Let's turn it around," I asked. "What if the bank decided that it wanted to exercise the same sort of option?"

"What do you mean?"

"What if the bank foreclosed on your house, even though you made the payments, because it figured it could make more money taking the house and selling it?" (Not a likely scenario, I know, but a useful thought experiment.)

I could tell from his face that he didn't think this would be fair. But assuming that the bank can get away with it, why would it be wrong for them to do this? (We were discussing morality, not practicality) If you get to decide when they get the house, and when they get the payments, why is it unfair when they exercise the same option?

There is an outstanding reason that giving a mortgage borrower an "option" to cease payment, and forfeit only the security of the real estate is NOT like giving the bank the option of foreclosing to aquire increased real estate value. When a mortgage borrower stops payment, they lose not only the property, but also all the accumulated equity they have acquired. The bank does not give any money back. The value of accumulated equity lost should be sufficient to compensate banks for their loss of "options" inside a mortgage contract.

The simple morality of mortgage loans aside, there are also sound macro-economic reasons to advocate no-recourse mortgage loans. Real estate bubbles are likely to have a significant and negative effect on the economy at large, affecting even people and businesses who act responsibly. Banks are unlikely to encounter large numbers of people giving up their mortgage equity unless there is a severe devaluation in the real estate market, and a bubble is the most likely cause of this. No-recourse mortgages provide an incentive for banks to discourage, rather than encourage notable real estate bubbles and misvaluations.

This incentive is important even though it is not likely that it will eliminate large market corrections on a multi-generational timescale, like the present economic downturn.


The majority of real estate bubbles and misvaluations take place on a local scale, and will take place at any point in the overall economic cycle. At this very time, there are still a few areas of the country like portions of North Dakota where bubbles are present, or are a risk. These many little bubbles will cumulatively inflict significant economic damage on a national economy over time, unless, and to the extent that they are suppressed. Banks are inevitably better equipped to appraise real estate and evaluate value than most members of the public, and non-recourse mortgages encourage banks to convey this information, or at a minimum, act on their own pricing information to forstall real estate bubbles built on borrowed money, rather than hide this information.