Kedrosky on the Loan Default Myth

by Alex Stenback on January 29, 2008

A post sure to terrorize lenders already having a puke-fest over the growing "social acceptability" of walking away from an upside down home, via Paul Kedrosky:

I get irritated at the line of argument that says the world was a better place when consumers let burdensome loans wreck their families, and drive them personally into the ground like over-sized tent pegs. Enough.

Yes, people used to be much more nervous about defaulting. But so what? If a loan no longer meets your requirements, or if it’s crushing you financially, or if your circumstances have changed, there is no need to go leaping off bridges about it. The world has changed and the consequences of loan defaults & loan renegotiations are no longer need be as dire as they once were. People who pretend otherwise are selling something — usually an over-rosy picture of an imaginary past.

It’s about time individuals caught up with countries and companies. Both have always had more flexibility with respect to loan defaults/renegotiation than individuals have. While I’m not suggesting that loan commitments should be as fickle as, say, high school relationships, I am saying that imagining they they need to remain financial straightjackets is not rational. It is a mindset that prevents some appropriate people from getting loans who might appropriately get them (they may have the resources but are afraid of the commitment), and it keeps some people in loans who should have long ago been let out.

We agree completely.  Much of the lunacy in residential mortgage lending over the past few years was based in part on the belief that Americans would pay their mortgage no matter what – even if it was economically irrational to do so.  Looks like this premise is going to be tested, and many lenders will find out that the American homeowner can be just as financially ruthless as the business world has always been. 

{ 4 comments… read them below or add one }

Miranda January 29, 2008 at 12:12 pm

I like the idea of being able to renegotiate mortgage loan terms. Especially in extenuating circumstances. And I’m not just talking about loan refinance. Being able to go to a mortgage lender, like you can do with a credit card, and say “Look, I’ve done a good job here, I deserve a lower rate” would be a good thing.

And being able to renegotiate mortgage loan terms for those with economic problems would allow them to keep their homes, and the mortgage lenders would still get their money.

Nate January 29, 2008 at 4:24 pm

Calculated Risk did a long write up today on the options theory and mortgage pricing. Does a good job explaining how lenders are going to be forced to price this into their mortgage models. As it seems the current models have been based on the assumption that people traditionally tend to default more during periods of high interest rates.

Since we are now enjoying a market with very low interest rates, but very high (and increasing) levels of defaults, they make the arguement banks will need to adjust. Seems to imply higher lending costs will be a required change in the industry.

But if lending costs get more expensive, either through rate increases or other fees, it has to have a negative effect on housing prices. Additional pressure on housing prices would push more people into negative equity on their homes, which would lead to more intentional loan defaults.

How can banks work their way out of this if prices continue to decline?

Nate January 29, 2008 at 4:39 pm

Also, in case anyone thinks this isn’t gaining in popularity, check out this link.

Editor/Alex January 29, 2008 at 4:50 pm

You know, I had a paragraph in that original post about the likely consequences – higher rates, down payments, etc. – but cut it becuase I was running short on time.

I’ve linked up the final para of CR’s post on that topic – another awesome post by CR/Tanta.

I happen to think that the lenders properly re-pricing risk in this way will contribute to the long term health of the housing market in the sense that it will keep things from getting too overheated and speculative again for a long time.

In the short term, it will add to the downward pressure on prices, depending on how bad the jingle mail problem gets, and how quickly lenders adjust for this added risk factor.

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