Strategic defaults—the phenomenon of people who could continue to make payments on the mortgages on their homes deciding to walk away from their obligations—are rising. According to the Wall Street Journal, strategic defaults are likely to exceed 1 million in 2009. This is making some worry about the very future of capitalism. Georgetown University business ethics professor George Brenkert told the Journal that borrowers who can afford to stay current are morally required to do so, and that were Americans to conclude they could just walk away from obligations, it would be disastrous. Mortgage Bankers Association CEO John Courson wondered about "the message they will send to their family and their kids and their friends?" Blogger Megan McArdle expressed disdain for people who chose to indulge themselves on consumer goods and services while not keeping current with their mortgages.
Um, do any of these people read the Wall Street Journal? Strategic defaults are the American way, and I'm not talking about strapped middle-class borrowers who prefer spending money on vacations to staying current on their payments. Deep-pocketed companies, billionaires, and institutions that can afford to stay current on payments strategically default all the time.
Morgan Stanley, for example, is a gigantic corporation. As of the second quarter, it boasted total capital of $213.2 billion. It certainly has the ability to make good on obligations incurred by its many operating units. But earlier this month Morgan Stanley said it would turn over five San Francisco office buildings to lenders rather than pay the debt on them. Why? Morgan Stanley foolishly paid top dollar for the buildings in 2007, when prices were really high. The values have plummeted, and tenants are hard to come by. "This isn't a default or foreclosure situation," spokeswoman Alyson Barnes told Bloomberg News. "We are going to give them the properties to get out of the loan obligation." Smells like a strategic default to me.
It's not just happening in real estate. According to Standard & Poor's, through Dec. 18, 262 corporations had defaulted on bonds they had sold to the public, twice the total of 2008 and "the highest default count since our series began in 1981." Like mortgages, corporate bonds are legal arrangements in which parties—in this case companies, or partnerships, or limited liability corporations—agree to pay money back. Sometimes companies default on these bonds because they're broke (see: Lehman Bro.). But sometimes they simply default because they don't want to pay out for them. Investors and managers, who have spent hundreds of millions of dollars on personal toys, aircraft, headquarters buildings, and compensation, simply can't seem to find the cash to stay current on debts.
KKR, the original private-equity firm, manages about $55 billion. Its founders are billionaires several times over. But when Canadian door-maker Masonite, one of KKR's portfolio firms, ran into trouble staying current on $2 billion in debt, the partners were content to let the firm miss an interest payment and file for Chapter 11. Of course, the debt in this case rested on Masonite, not KKR. But firms whose business model rests on constantly borrowing large sums of money should, in theory, be taking heroic steps to avoid defaulting on debt.
Or take amusement-park operator Six Flags, which filed for Chapter 11 because it couldn't make good on a $300 million interest payment coming due. The company didn't have the resources. But its biggest shareholders sure did. Bill Gates owned about 11 percent of the shares through an investment vehicle. Daniel Snyder, the Redskins owner and marketing wunderkind who had taken control of the company in 2005 and installed his own management team, owned 6 percent. Snyder could have sold off the Redskins or tapped into his personal fortune to stay current on Six Flags' debt. But he chose not to. And most analysts and investors think he would have been stupid for doing so.
Sometimes, investors and managers take heroic, self-abnegating efforts to stave off bankruptcy and make their debt payments. Frequently, however, they don't. They don't want to throw good money after bad. They realize that some investments were so poorly conceived that there's no prospect of them working out in the long term. And the system doesn't hold it against them.
There's no doubt that homeowners are defaulting strategically. And the surprise may be that, given market conditions, there aren't more strategic defaults. A paper by University of Arizona law professor Brent White suggests that bourgeois values are actually keeping people from walking away from bad home loans. Most people underwater on their mortgages stay current "as a result of two emotional forces: 1) the desire to avoid the shame and guilt of foreclosure; and 2) exaggerated anxiety over foreclosure's perceived consequences." In addition, he notes, societal norms push individuals "to ignore market and legal norms under which strategic default might not only be a viable option, but also the wisest financial decision."
Of course, corporate managers and financiers don't suffer from these neuroses. Do you think billionaire investor Sam Zell feels any guilt or shame because his buyout of the Tribune Co., which had $12.9 billion in debt, ended in a Chapter 11 filing last December? Rather than worry about whether Americans will take cues from modest homeowners who make a tough decision not to stay current on debt, perhaps we should worry about middle-class Americans taking cues from billionaires and Fortune 500companies who make the rational decision not to stay current on debt.
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