The Great Debate

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Call me a default-ista.

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.

First, homeowners. Something approaching 50 percent of U.S. mortgage-holders are underwater, meaning the value of the property is less than the value of the mortgage. If a second leg down in housing is under way, that figure will get much higher and the distance to the surface much longer.

It is an axiom of mortgage lending that it is usually far better for the lender to modify, or to cut the principal or repayments, than to suffer the expense of a default. Yet, what few modifications are being done are usually not nearly generous enough to give the borrower an honest economic interest in sticking with the loan.

Many of these borrowers would themselves be better off with a default; better off not overpaying for an asset rather than renting more cheaply, better off because they are not in a stable enough situation for homeownership and better off because it would leave them free to pursue jobs and opportunities elsewhere.

As for the threat of a ruined credit history, you could argue that many of these people’s long-term economic outcomes would improve if they were denied access to credit for a period of years.

The housing bubble was a massive, historic misallocation of capital. Wanting borrowers to keep paying over the odds for an asset, housing, which should be allowed to fall in price is to want to keep misallocating that capital. Rather than keeping house prices high and mortgage portfolios sound, the money that might go to repayments and interests would instead go to either consumption or investment in some other more rewarding area.

There are good reasons for the stigma against default; societies in which people can be counted on to honor their contracts generally produce better, fairer outcomes and are vastly more efficient.

Some will argue that if there are a lot of strategic defaults — defaults undertaken not just because a borrower can’t pay but because it is in their best interest not to pay — loans will become harder to get and more expensive.

Absolutely, and a good thing too, for banks and borrowers.  Let the bad lenders take their losses and, if need be, fail.

THE DRUGS DON’T WORK
For nations, default too, in some form, can be the best option. For Greece, and arguably for others, the austerity that many believe is required to make good the debts will put their populations through crushing recession. What’s more, the suffering may well be in vain for, as the austerity kills growth, ability to repay will diminish further.

Look at Ireland, whose austerity program seems to have convinced capital markets that it is a worse rather than better risk.

Speaking about the U.S. debt situation at a recent Morningstar conference, fund manager Jeffrey Gundlach of DoubleLine LLC pointed out that U.S. debt was now 353 percent of gross domestic product, or about 20 percent more than in 1933.  For more, click here.

He framed the situation well, noting that there were six ways to dig oneself out of a debt hole.

The first, growth, does not seem to be happening, at least in part because of the dead weight of debt and the lousy way it was allocated.

We are at the limits of the second, lower interest rates, so not much to hope for there.

A transfer payment from outside, the third, might work for Greece if Germany obliges, but is not a scalable solution.

Increasing taxes or cutting spending, Gundlach’s fourth option, are both politically difficult and could cause a downward spiral.

We’ve already printed money, the fifth option, and in my opinion may well print a whole lot more.

Option six is default, and Gundlach predicated some form of “polite default” from the United States either on entitlements or debts.

That I am not sure about, but what is clear is that the United States, because it did not want to sort out its banks properly, took on what may prove to be an unsustainable debt load in order to keep the collateral underlying the system afloat.

Default, like pain, is a very useful signal that something is not right. If you mask it or make it too difficult to register you will carry on doing the things that are damaging.

In the end the banking and financial system is there to support the economy and the people who live in it, not the other way around.