The Loan Default Myth

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.


  1. If the underlying asset is valued properly, it shouldn’t be difficult to get out of it. Good point, Paul.

  2. I agree, good comment. It is not different than the poor schmuck working at IBM and the company, still cranking out a $10 Billion profit says, too bad, this pension plan doesn’t meet our needs, you lose. Companies have taught us by their actions that its OK to walk away from commitments.

  3. You may feel differently about this if you were the one that lent the money. Along with your idea will you also add a check box on the loan app that ask: “I am taking this loan seriously and in good faith” or “I just want to try this loan and see if it works. I will pay it back if everything goes as I plan”.
    You forget that the person who lent the money does not have the same ability to change his mind. Both sides of the loan must be equal. Now if you will give me, “the lender”, the ability to call the loan due if I change my mind then maybe we have something to talk about.
    (BTW…can you loan me a few hundred, I promise to pay you back next thursday)

  4. Wait till China and the Midle East decide to quit putting on the party for those that do not want to uphold their committments. I think they m ight ask for more interest. I confess that I am not a Californian, my you know what does stink, the world does not owe anything just for being my conceited arrogant self, and I am willing to pay taxes for needed services.. If no one followed through on their committments you would have chaos.

  5. It would end such practices as 125% or even 100% loans, stated income loans, and reduce teaser rates and subprime loans, but I won’t miss them. More fear and less greed is warranted.

  6. Credit and “risk” capital are put forward based on a “degree” of faith and behaviour in the borrower. when that trust shifts, capital disappears. Credit is assigned in a portfolio fashion somewhat similar to a commons. When a few take from the commons the aggregate suffer. Where would you make a loan in Nigeria “a low trust culture” or Iceland a “high trust culture”. Check out to learn more on comparative values and economics. It is interesting stuff. America’s values change as all cultures change, and our “price” of credit will adjust accordingly for all of us.

  7. Chris said:
    “If the underlying asset is valued properly, it shouldn’t be difficult to get out of it.”
    That’s inaccurate Chris. Individual debt causing bankruptcy is not from mortgages but primarily consumer debt. That’s debt acquired for consumer goods and services which by their nature are not backed by any asset directly.
    Paul your stance that more flexible debt terms will actually remove “financial straightjackets” on credit worthy borrowers who hit trouble is doubtful. Relaxing debt terms has the effect of severely tighten money supply. Banks and CC cos. will be very hesitant to loan money to borrowers without the highest credit ratings if the cost of default or renegotiating is low. The fact that it is costly to declare personal bankruptcy is a major reason you can buy your car or couch with no money down or take that Vegas Vacation on credit.
    I’m not saying it’s a bad idea to loosen terms, it would force lenders to better evaluate risk before lending funds for consumer goods and services. It would also increase the US savings rate which is abysmal. However, it would not have the affect that Paul is espousing.

  8. If you make it easy to walk on home loans they become put options not loans. Loans already include a favorable option for the home owner, the ability to refinance early if rates drop.
    You’re just proposing rent with an option to buy under a different name. But at least in the rent to buy case the landlords actually know they are landlords.

  9. Trust is an essential part of the financial system. Lenders assume that borrowers will strive mightily to fulfill their commitments, and not just casually decide to default even if they can afford to carry the property because the property value may have declined modestly.
    Paul, would you feel the same way if venture firm LPs decided not to fulfill their capital call commitments in years 2 through 4 because the first year of a fund’s life wasn’t a blow out?
    Housing is a long term asset. Mortgages are (usually) 30 years in length. It supposed to be a long term commitment on both sides – not a day trade.
    We should all think long and hard about whether we it’s OK for parties with the means to honor a financial contract to decline to honor it because they have buyer’s remorse. There are enormous economic externalities to trust in a financial system – I think this post dramatically undervalues trust as an asset.

  10. John in Hawaii says:

    Housing market imploding, loans doled out like crack on a corner on “The Wire”, stock market tanking, recession looming and yet Wall St. hands out bonuses once again. When banks, 3rd world countries, large corporations can simply walk away from a committment; why is it illegal for the individual to do the same? House underwater? Screw it…here’s the keys. Credit screwed for a few years and we’ll work it out again during the next bubble! Human nature doesn’t change.

  11. Paul in UK says:

    djames says
    ‘You forget that the person who lent the money does not have the same ability to change his mind.’ – not so. In most cases where there is a personal debt (loan, overdraft) the lender can decide it wants to call in the debt at very short notice.