Strategic Default and Duty to Shareholders

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Steve Waldman submits:

Megan McArdle thinks strategic default by underwater homeowners is not okay:

I am afraid that I am one of those people who have no patience for people who refuse to pay their debts… There is a sizable school of thought that says why shouldn't they? They made a contract with the bank under known rules, and as long as they're willing to pay the penalties, why shouldn't they just walk away, the way a corporation would? Well, for one thing, companies don't always behave like this, and those who get a reputation for stiffing their suppliers run into trouble. But for another, because society doesn't really work on such clean logic. The reason we can have easy bankruptcy and a pretty robust credit market (usually) is that most people act like debts are obligations which should always be paid off if possible.

I would like to agree with her. I think that if we structured the economy so that I could agree with her, we'd have both a better world and a more prosperous economy.

But, in the world as it is, in this mess as we've made it, her position is beyond unfair. Businesses walk away from contracts all the time, whenever the benefits of doing so exceed the costs under the terms by which they are bound. McArdle is certainly right to point out that companies frequently honor costly bargains they could get away with breaking, because their reputations would be harmed by walking away. But, reputational costs are economic costs. They are a part of the cost/benefit analysis that firms use in making decisions. It is not virtue that binds them to keep their word, but medium-term self-interest. Similarly, homeowners consider the hit to their credit rating and potential loss of social standing prior to walking away.

The question is whether debtors should keep paying off loans simply because it is the "right thing to do", even when, taking all financial and non-financial costs into account, they would be better off reneging. A human being can choose to be "upright" in this way, if she wants. But under the prevailing norms of business, managers of all but the smallest firms can not so choose. To do so would be unethical.

Let's recall Milton Friedman's famous essay, The Social Responsibility of Business is to Increase its Profits :

In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers… Of course, the corporate executive is also a person in his own right. As a person, he may have many other responsibilities that he recognizes or assumes voluntarily… He may feel impelled by these responsibilities to devote part of his income to causes he regards as worthy… spending his own money or time or energy, [but] not the money of his employers… [T]o say that the corporate executive has a "social responsibility" in his capacity as businessman…must mean that he is to act in some way that is not in the interest of his employers…spending someone else's money for a general social interest… Insofar as his actions…reduce returns to stockholders, he is spending their money. Insofar as his actions raise the price to customers, he is spending the customers' money. Insofar as his actions lower the wages of some employees, he is spending their money. [H]e is in effect imposing taxes, on the one hand, and deciding how the tax proceeds shall be spent, on the other… [He] is…simultaneously legislator, executive and jurist.

In 1970 when Milton Friedman published these words, I think they must have seemed a bit radical and weird. But today this view is triumphant, both in theory and in practice. Mainstream theory and law views a corporation as a "nexus of contracts" between consenting individuals. Firm managers are agents, employed to act in the interest of shareholders. Shareholders are imagined to unanimously share a single goal - maximizing financial value. When a manager acts in a manner inconsistent with that overriding goal, for motives virtuous or vile, she is imposing "agency costs" on her employers, expropriating resources which are not hers. She is behaving unethically.

An individual, on the other hand, is not so conflicted. Her resources are her own. If she acts against her interest, she harms only herself, and most of us agree that there are times that virtue demands she do so (though we've no consensus on just when). McArdle can argue that individuals should pay obligations they'd be better off shirking, in the name of a larger, social good. But under the now prevailing view, she can't ask that of businesses, because that choice is not firm managers' to make. If managers or some shareholders wish that a costly action be taken in the name of social responsibility, Friedman helpfully reminds us that they "could separately spend their own money on the particular action if they wished to do so."

In practical terms, exhortations to individuals that cannot apply to firms leave us with what Felix Salmon aptly describes as " the world's largest guilt trip ":

The result is a system tilted enormously in favor of institutional lenders who exist in a world of morality-free contracts, and who conspire to lay the world's largest-ever guilt trip on any borrower who might think about joining them in that world. It's asymmetrical, it's unfair… no one would expect a capitalist company to behave in the way that individuals are being told to behave…

Individuals must operate in a competitive economic environment dominated by entities constitutionally incapable of overriding self-interest to "do the right thing". Virtuous individuals can expect no reciprocity from the firms with which they contract. They have two choices: live nobly and get screwed, or adopt the amoral norms of their counterparties. It has taken some time, but we are all coming around to the only supportable view. "It's just business," we shrug, even if we never wanted to be businessmen.

At this moment, the amorality of the transactional, profit-maximizing firm has seeped into most of our commercial relationships. This contributed grievously to the financial crisis: employees of Wall Street firms do not view themselves as morally bound to the fate of their employers, but as atoms negotiating the best terms that they can for themselves. When they found themselves able to enter into arrangements that offered irrevocable cash payments against uncertain accounting profits, they did so eagerly. When flippers discovered they could borrow huge sums of non-recourse money for real estate, and capture huge gains with little personal wealth at risk, they did that too. Asking flippers not to put back underwater property is precisely analogous to asking Wall Street whizzes to give back their exorbitant pre-crisis earnings. The latter won't happen, so the former should not. Given where we are, every underwater homeowner should absolutely act ruthlessly in her self-interest. If that leads to further turmoil and collapse at the banks, so be it. I see no reason why deeply flawed institutions should be sustained on the backs of the virtuous, via a kind of stupidity tax.

It didn't have to be this way, and going forward, perhaps we can find a way out. As I said at the start of this essay, I'd prefer to live in a world where I could agree with Ms. McArdle. It was not inevitable that we conceive of the firm as a nexus of contracts without agency for moral action except via implausible relegatation to shareholders. That is just one of many possible ideologies, and a rather idiotic one. The core notion that shareholders "own" the firms they fund is, in my view, a poor definitional choice.

But so long as the "social responsibility of business is to increase its profits", the social responsibility of customers is to look to their own self interest. Even if that means dropping their house keys in the mail and renting the place next door.

See also Backtesting a Value Strategy on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

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