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In praise of default

Hi James,

by Katharine Herrup 7/6/2010 5:00:31 PM
It's time

by Katharine Herrup 7/6/2010 5:00:44 PM
Are you ready to start?

by Katharine Herrup 7/6/2010 5:00:58 PM
Do you see the above comment from Leo7777? Can you respond to that please?

by Katharine Herrup 7/6/2010 5:01:32 PM
Hi Katharine, hi everyone. Thanks for coming along.

by jamessaft 7/6/2010 5:02:08 PM
Yes, I see that and obviously there can be huge prices for a sovvie default.

by jamessaft 7/6/2010 5:02:41 PM
I'd say that the Argentina example, which was totally disorganized and a foulup, is not a good template.

by jamessaft 7/6/2010 5:03:02 PM
But Carmen Reinhart, no less, has pointed to Uruguay's default as one that was handled well and where the country quickly returned to growth.

by jamessaft 7/6/2010 5:03:50 PM
Reinhart is a well known economist and the co-author of This Time Its Different, and examination of 800 years of debt crises.

by jamessaft 7/6/2010 5:04:48 PM
Isn't it irresponsible for homeowners to default? Shouldn't they pay the money that they said they would pay?

by Katharine Herrup 7/6/2010 5:06:22 PM
Watchers, please feel free to write in questions.

by Katharine Herrup 7/6/2010 5:06:34 PM
Well, I'd say that the big mistake was to take out the loan in the first place, and the other huge mistake was for lenders to give credit in the way they did.

by jamessaft 7/6/2010 5:07:29 PM
It would be wrong to suffer economically for years in order to keep a bank from suffering the consequences of its actions. If you are a corporation, for example, you can have a legal obligation to shareholders to default if it is in their best interests. I don't think it is a whole lot different with individuals.

by jamessaft 7/6/2010 5:08:35 PM
A board of directors of a company has a fiduciary obligation to shareholders to act in their best interests.

by jamessaft 7/6/2010 5:09:32 PM
From James Saft's piece today, "In praise of default":

For a huge number of borrowers, be they U.S. homeowners or the sovereign nation of Greece, a default or radical rescheduling of debt might just be the best, most practicable option.

More to the point, default in many of these situations may be not just in the best interests of the debtor but of the economy as a whole.

Read more: blogs.reuters.com

by Katharine Herrup 7/6/2010 5:09:41 PM
a comment from Leo7777 on Jim's piece:
well, in case of private investors or homeowners this may be the right option, but in case of sovereign states, a default may actually be better in the-very-long term, but for 5-7 years the whole population of the country will be thrown to the lions! I mean, extreme poverty, huge unemployment, a diplomatic fiasco in any foreign affairs it may have and a precedent that will remove any serious foreign investment out of the country for many years-and when I mean serious foreign investment, I don’t mean corporations buying a states property for a dime…

by Katharine Herrup 7/6/2010 5:09:43 PM
That means if it is better for shareholders to default and they do not they can be sued.

by jamessaft 7/6/2010 5:09:48 PM
They can't act in the best interest of the bank and not the people they work for, i.e. the shareholders.

by jamessaft 7/6/2010 5:10:31 PM
An individual should, within reason, act in their own best interests too. Clearly banks are, so so should homeowners.

by jamessaft 7/6/2010 5:11:20 PM
And that often means defaulting.

by jamessaft 7/6/2010 5:12:09 PM
If you have a house that is 30 pct underwater and you can rent for far less, better to take the hit to your credit rating than spend the next 20 years defending the bank's balance sheet.

by jamessaft 7/6/2010 5:12:53 PM
but doesn't defaulting on your mortgage decrease the value of homes around you?

by Katharine Herrup 7/6/2010 5:13:41 PM
Sure it does, but I think that is a good thing!

by jamessaft 7/6/2010 5:14:47 PM
The purpose of a house is to house someone rather than to go up in value.

by jamessaft 7/6/2010 5:15:02 PM
We had a huge bubble in the US and it has not really served peoples' needs well. Anyway, my view is that house prices have to return to some semblance of affordability and the issue is how long we take getting there. People should view housing not as an investment but as consumption.

by jamessaft 7/6/2010 5:16:25 PM
Take NYC, for example...

by jamessaft 7/6/2010 5:17:24 PM
House prices there have gone up hugely over 25 years but while that has enriched people with a lot of exposure to NYC real estate, it has shut many out and forced many middle class people to devote silly amounts of their income to housing.

by jamessaft 7/6/2010 5:18:25 PM
Obviously, not everyone can live in NYC, but it is an extreme example of what has happened in many places.

by jamessaft 7/6/2010 5:19:05 PM
It may be reasonable for one person to default on his mortgage, but if all 50% who are underwater do so, it seems to me, not being an economist, that the results would cause all banks to go under.

by John Klokow 7/6/2010 5:19:31 PM
Perhaps if everyone who was underwater defaulted all at once you are correct, but a lot of people who are marginally underwater probably should not and the effects might be manageable. I guess the question comes down to the issue I tried to raise at the end of the story: is the financial system there to serve the economy and the people in it or the other way around?

by jamessaft 7/6/2010 5:21:17 PM
We've had bank failures in this country forever, and we have a good way of handling them. I don't think we need to take money from borrowers to keep a crazy house price regime up in the air. Let it come down!

by jamessaft 7/6/2010 5:22:21 PM
so what's the underlying logic of avoiding defaults and rescheduling across both mortgages and sovereigns?

by Katharine Herrup 7/6/2010 5:23:55 PM
Well I think John Klokow touched on that.

by jamessaft 7/6/2010 5:24:31 PM
The common denominator is that avoiding default avoids having to deal with a banking system that is, probably, insolvent.

by jamessaft 7/6/2010 5:25:14 PM
If Greece comes down it hits French and German banks, if Mrs Jones defaults it hits U.S. banks.

by jamessaft 7/6/2010 5:25:40 PM
My take is that the US administration took a decision early on that they did not want to have to take very large US banks into administration. The decision to support house prices with a silly tax break, by buying mortgage bonds and through other means was to keep house prices up so banks could earn their way out of the hole.

by jamessaft 7/6/2010 5:27:01 PM
@jamessaft I think what John Klokow is getting at is that if people start defaulting and it sets a property price drop spiral putting more people under and thereby providing more reason for others to default.

by HK 7/6/2010 5:27:43 PM
Thanks HK. Yes, that is a risk, but the fact is that we were in a spiral downward already, and had been in an upward one for about a decade. I'm not sure that breaking that spiral was in the general interest. I also think that property in the US has an inherent value and once we reached that the cycle would end.

by jamessaft 7/6/2010 5:29:09 PM
But good point, and I do know I am playing with fire on this one!

by jamessaft 7/6/2010 5:29:20 PM
does defaulting now make it much harder to purchase a home in the future?

by Katharine Herrup 7/6/2010 5:30:49 PM
Yes, depending on where you live and the terms of your loan. You can generally expect to be shut out of credit for several years, and so that is a cost that people in this situation should weigh.

by jamessaft 7/6/2010 5:31:41 PM
I guess my point is that if you have obligations that are way more than you can afford acess to credit is not going to solve your problem.

by jamessaft 7/6/2010 5:32:12 PM
How many months of unsold housing inventory exists in the US?

by jimmy 7/6/2010 5:33:18 PM
I think it is about 8.5, at least that is where it was in May, may have moved up slightly.

by jamessaft 7/6/2010 5:33:44 PM
Thanks for your reply

by HK 7/6/2010 5:35:55 PM
@jamessaft I think the window of action was missed when Hank Paulson went to Congress with hat in one hand and Helicopter Ben's hand in the other. A more prudent way of handling the debt would have been to give the homeowners vouchers up to 5 years of tax receipts to be used solely for mortgage payments. The vouchers would be a simple interest loan at maybe 5% p.a., it would have kicked the ball much further out and given everyone time to find their bearings. This would have in effect nationalised the debt, but the panic and increase in unemployment would have been stemmed as the spigots would not have just shut off.

by HK 7/6/2010 5:35:58 PM
8.3, I just checked!

by jamessaft 7/6/2010 5:35:59 PM
I guess that has the advantage of directing the relief to homeowners effectively.

by jamessaft 7/6/2010 5:36:40 PM
HK mentioned 'what I was getting at'. My point was just the simple one that a strategy that is very good for a single person, may not be very good if all the person in the same situation act on it. I know this is a well-know topic from game theory perhaps.

by John Klokow 7/6/2010 5:37:34 PM
Would have to think that one through, but still I am not at all convinced that a regime to support house prices is good public policy. I'd rather let it fall and deal with the consequences. Interesting though.

by jamessaft 7/6/2010 5:37:37 PM
any final queries?

by Katharine Herrup 7/6/2010 5:38:27 PM
or, James, is there anything you would like to address that didn't make it into your column?

by Katharine Herrup 7/6/2010 5:38:48 PM
But in general I think Mr. Saft's idea is thought-provoking; which I may attempt to rephrase as "Why should an individual suffer pain to maintain inflated housing prices which are economically not useful, even harmful?"

by John Klokow 7/6/2010 5:39:08 PM
last call for questions

by Katharine Herrup 7/6/2010 5:39:32 PM
I would say that I'm not pretending that these are easy issues, and of course there are risks to what I am proposing.

by jamessaft 7/6/2010 5:40:12 PM
@jamessaft I think the benefit would have been to reduce the interest load on the debt as the premium tax payers would have paid over the rates the federal government's cost of credit. I wonder why economists never discussed this as a solution.

by HK 7/6/2010 5:41:01 PM
Thanks very much to everyone who joined in today. Special thanks to James for answering all the questions.

by Katharine Herrup 7/6/2010 5:41:38 PM
Till next time.

by Katharine Herrup 7/6/2010 5:41:46 PM
Thanks all. I enjoyed it.

by jamessaft 7/6/2010 5:41:46 PM
Over and out.

by Katharine Herrup 7/6/2010 5:42:00 PM

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Live Chat with James Saft

In praise of default

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