Moral Hazard and Obligation

Imagine you are at a flea market with a friend. As you wander the aisles you come upon a stall selling what your friend tells you very quietly so as not to alert the other customers is a mint condition version of the 5.75 inch tall “Christmas Delivery” Hummel figurine.

Your friend isn’t as discreet as he thinks, though. Another customer wanders over to look and it’s clear that she also recognizes the potential find which is priced at $400. A bidding war with the stall owner begins and at the end of it your friend has agreed to pay $700 for this chunk of porcelain. Problem is, the merchant will only take cash and your friend only has $300 on him.

You agree to lend your friend the remaining $400 but being who you are you make him sign a basic IOU with a payment date on it. This contract reads simply “I [your friend’s name] agree to pay [your name] the sum of $400 by [some specified future date].” Being a friend, you aren’t even going to charge interest. Your friend happily signs and you fork over the cash.

Two weeks later that new reality show “Trash or Treasure” comes to your local convention center and your friend stands in line for hours with his flea market prize carefully packaged. He just knows that the show, which often offers to buy the rare collectibles it has just evaluated to create that reality TV drama, will be happy to snap up his mint-condition item for at least what he paid for it, if not more, as the full retail asking price is about $1,500. Your friend is one of the lucky ones who gets an appointment with a screener evaluator and after hearing the flea market bidding war story and looking over the figurine your friend gets recommended for an on-camera session with the host, a famous antiques expert.

The antiques expert evaluates the figurine and tells your friend, unfortunately, no, this isn’t the version of this particular design that retailed for $1,500. This is the smaller version that retailed for $600 and even in the excellent condition it’s in the fair market value for the piece is only about $200. Your friend declines the offer of $200 and you both quickly leave the convention center.

A couple of days later your friend comes over to your house. He says that even though he borrowed $400 from you at the flea market since it turns out the piece that he bought isn’t actually as valuable as he thought he only wants to pay you back $100, and he wants you to change the IOU he signed to reflect that he only owes you $100 even though he borrowed four times that amount.

Stop and think about this for a minute.

Your friend purchased something that he thought was worth the price, if not more, than he paid. He had to borrow money from you in order to make that purchase. Now that it turns out that item isn’t worth what he thought it was he doesn’t want to pay back the actual amount he borrowed he wants to pay back what he would have borrowed if the asking price on the item had been lower.

He borrowed $400, spent it on something he chose to buy, and now only wants to pay back a quarter of what he owes because he overpaid. Seems pretty ridiculous, doesn’t it?

There is no difference between this scenario and the scenario proposed by some politicians and “thought leaders” and the “principal write downs for underwater homeowners” discussed in this clip from the May 2nd edition of Chris Matthews’ show “All In.”

Matthews and his guests discuss a report from the Congressional Budget Office (CBO), which is a non-partisan entity , that says cutting the principal amount owed by underwater homeowners on their mortgages would benefit the homeowners, the economy, and the American taxpayers.

For reference: In mortgage parlance “principal” is the amount borrowed from the bank, the $400 in my flea market example, and “underwater” means that the borrower owes more than the house is worth on the fair market.

Also worth defining “moral hazard,” which gets thrown around a lot in the clip from the Matthews show. “Moral hazard” is the idea that the borrower needs to have some stake in the transaction, something at risk, otherwise he has no incentive to honor the agreement. A better example of “moral hazard” is a car insurance policy with no deductible. With nothing at risk in the case of an accident, someone who owes money on a car has no incentive not to total that car and simply be repaid by her insurance; the deductible, that “skin in the game” that business creeps are so fond of discussing, is what prevents that “moral hazard” behavior.

Setting aside the wonky complexity of how encouraging banks to take big write-offs on loans could be a benefit to taxpayers, I’d like to look at the legal and moral ramifications of writing down principal on underwater mortgages.

From a legal perspective it’s a horrible precedent to set in contract law. I admit I am not a lawyer, nor am I an expert in contract law, but I do know that one of the basic principles of contract law is if you sign a valid contract you are legally obligated to honor that contract. Buying something for more money than it’s worth doesn’t make your contract invalid. It makes you a not very smart buyer.

If writing down principal on mortgages that are underwater is allowed, what are the ramifications for every other contract written in America? Can I suddenly decide that I don’t like the color you painted my house so I’m only going to pay you 50% of the price I signed for in the work contract? Or how about my car? A new car begins to depreciate as soon as you drive it off the dealer’s lot. Since it’s now worth less, does this mean I am only obligated to pay what it’s worth and not what I borrowed to purchase it? I realize these are broad, simplistic questions but I think they highlight something no one who is eager, so eager, to “fix” the housing market crisis is even considering.

Allowing these kinds of contract alterations introduce an element of uncertainty into every other contract that follows them and the whole point of contracts is they eliminate uncertainty.

Lawyers and legal pundits who are in favor of this type of “principal write down” will argue that banks would be making these decisions of their own volition and when two parties agree to alter a contract all it takes is an addendum to that contract to make the alteration. They will likely denigrate any concerns about the broader impact on contracts and contract law. And that’s fine but it still doesn’t get to the moral objection to doing this.

Strip away the cases of lender malfeasance, because that’s not what we’re talking about at this moment. Strip away the fact that the homes are worth less than the buyers originally paid for them. Strip away the unfairness to people who are faithfully paying their mortgages and whose homes aren’t “underwater.” Strip away how you feel about “Wall Street” and banks in general and go back to the two friends at the flea market.

I have sympathy for people whose homes are “underwater.” When you’re tied to the damn house you can’t move to find work, go to school, or care for an aging family member who needs help without seriously damaging your credit rating and reputation. It’s horrible and it sucks, but it doesn’t negate the fact that at some point you signed your name and borrowed that money and agreed to pay back at the bare minimum that amount.

By allowing “principal write downs” the message that would be sent is you don’t have to be competent and there are no consequences for the judgements or decisions you make. Buy whatever you want at whatever price you want and someone will always be there to pay for your mistakes.

Is this a message we really want to be sending on a policy level?

It also means from a personal relations perspective that your word, your promise to do something, is inherently of no value, and that is even scarier to me.