McArdle calls Memphis a poster child for moral hazard in mortgages; does she have a point?

In today's Coffee & Markets podcast on The New Ledger, Ben Domenech and Francis Cianfrocca discuss a recent piece on The Atlantic's Web site called "The New Breed of Deadbeats." The author, economics blogger Megan McArdle, declares that she has "no patience for people who refuse to pay their debts," as opposed to those who are unable to pay their debts, typically because of losing a job or even because of a series of bad financial decisions.

McArdle links to a story in The Wall Street Journal about a Southern California family who "strategically defaulted" when the value of their mortgaged home plummeted. Then they began renting a luxurious home for much less than their earlier monthly payment. The WSJ's premise is that their is a positive flip side to what appears to be gaming the system:

People's increasing willingness to abandon their own piece of America illustrates a paradoxical change wrought by the housing bust: Even as it tarnishes the near-sacred image of home ownership, it might be clearing the way for an economic recovery. [emphasis added]

Thanks to a rare confluence of factors -- mortgages that far exceed home values and bargain-basement rents -- a growing number of families are concluding that the new American dream home is a rental.

Some are leaving behind their homes and mortgages right away, while others are simply halting payments until the bank kicks them out. That's freeing up cash to use in other ways.


McArdle thinks we should be outraged: "I think before you walk away from three different mortgages, you should explore life options that do not include $1,800 worth of new furniture." Besides the moral dimension of walking away from a deal, McArdle believes that there are real economic consequences -- a moral hazard -- when contracts aren't honored in a free market. To illustrate, she digs out a 1997 Fortune article on, yes, Memphis, which was then known as "the bankruptcy capital of America":

A visitor soon concludes that this boomtown has a culture of bankruptcy.

[snip]

There are serious costs to being the No. 1 deadbeat, of course. It's almost impossible to cash checks in Memphis. Used-car dealers charge their wholesale cost as a down payment. And lenders are either tightening or giving up. First Enterprise Financial Group, for instance, an Illinois-based sub-prime lender, closed its Memphis operations in May.

On the podcast, Cianfrocca dismisses the idea that what Fortune and McArdle said happened in Memphis would happen to the United States as a whole (the segment on McArdle is toward the end of the podcast). He also points to accumulating anecdotal evidence that banks are not allowing people to refinance their mortgages into lower-cost mortgages like they used to.

The whole country won't become like Memphis, not with Congress and the Administration pursuing a reflate-even-at-the-cost-of-moral-hazard policy, and with the Fed tacitly supporting that policy. If people who can afford to pay off mortgages on inflated property values continue to do so, then they will have shouldered the collapse of the housing bubble. McArdle implicitly believes this is a good and right outcome. I don't disagree in the slightest, but it does mean that we're facing years of economic underperformance.

UPDATE: Commercial Appeal Business editor James Overstreet touched on the moral-hazard theme in a column from a few weeks back. He noted that credit-card delinquencies are declining even while negative equity -- "underwater" mortgages -- continue to "hobble economic recovery." (The negative-equity rate is more than 25 percent in Memphis.) 

But consumers are making disconcerting choices about deleveraging their balance sheets: While not paying their mortgages, they are paying their credit card bills.

This is runs counter to the age-old adage that people will pay their mortgage first and everything else second.

Some observers attribute this change in consumer behavior to the unintended consequences of massive government intervention, namely "moral hazard."

Moral hazard happens when the government promises to bail out organizations or individuals if their behavior results in financial ruin.

In other words, there is no incentive to play it safe if you know you will get bailed out by Uncle Sam.

So if homeowners believe the government will bail them out of underwater mortgages, they'll just stop making payments and wait for the federal rescue.

Since such a bailout isn't available for credit card debt, they continue paying those bills.


Overstreet sees no sunny side, only more negative consequences, to Americans ditching their mortgages in order to increase their liquidity.

Also, check out this analysis of a study of Memphis bankruptcy filers by the Memphis-based RISE Foundation. It points out that, "Foreclosure avoidance was the clearest expression of why homeowners sought bankruptcy protection." 


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