Walking Away: Is Defaulting Now the Right Move?
Why strategic default is turning from a "moral failure" into a mainstream financial strategy (revised).
Ben Rabidoux here, friend of The Loonie Hour. Expect to see more of me contributing to The Loonie Hour’s Stack.
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Don’t underestimate the significance of a mainstream media headline like this in the Financial Post:1
[…] Toronto real estate lawyer Bob Aaron, who has decades of experience and still considers the Ontario real estate collapse of 1974 the worst time of his life, said he has advised several clients to file for bankruptcy.
“Sometimes we do go to the builder and say my client has no assets and you’re welcome to sue if you want, but they will go bankrupt, so how about a mutual release to keep the deposit, and that’s the end,” he said, adding that some developers will just say they already have the deposit and go after you anyway.
[…] If you can walk away without paying the house back everything, that is pretty tempting and maybe the right financial decision. I’ll let others decide if it’s the right moral one.
That same week, another article with the same advice:
Plummeting condo prices leave buyers with massive financial losses - CTV2
[…] “I’ve been a real estate lawyer for almost 50 years, and I’ve never seen anything quite like this,” said Vancouver-based real estate lawyer, Perry Ehrlich to CTV News via Zoom on Friday.
[…] “They’re going to have to come up with the money, either by borrowing or getting loans from relatives, or coming up with the money somewhere cashing an RRSP,” said Toronto-based real estate lawyer Bob Aaron to CTV News.
“Or in the worst-case scenario – I’ve had to refer some of my clients to trustees in bankruptcy because with the reconstruction contract, they are in a negative position as to their net worth and they’re going to have to go bankrupt.”
[…] Raszewska adds defaulting on the contract isn’t illegal, and perhaps the best option for some buyers is to walk away.
This is not a small development.
Here we reference a seminal 2013 paper published in the Journal of Finance, titled “The Determinants of Attitudes toward Strategic Default on Mortgages”3(the free access NBER working paper can be accessed here).
The authors show that mortgage default decisions are not driven strictly by financial factors, but are also heavily influenced by social norms and moral attitudes.
Using survey data, they find that many homeowners view defaulting on a mortgage as ethically wrong which acts as a powerful restraint on strategic default in normal times.
But this stigma is not static through time. It weakens significantly when borrowers are exposed to others who have defaulted, particularly within their social or geographic networks. This means mortgage default cycles often have an element of “social contagion”.
The authors’ key summary findings:
The most important barriers to strategic default seem to be moral and social. Ceteris paribus, people who consider it immoral to default are 77% less likely to declare their intention to do so, while people who know someone who defaulted are 82% more likely to declare their intention to do so.
While moral attitudes toward default do not seem to be affected by the surrounding environment nor by the anger people exhibit vis-à-vis the current environment, the social pressure not to default is weakened when homeowners live in areas with high frequency of foreclosures or know other people who defaulted strategically. Our results suggest that these contagion effects should be seriously considered in public policy regarding housing.
This is the sort of dynamic that risk managers will want to follow. I know some will point to “recourse” as a primary deterrent, but empirical data here is VERY clear: It’s only a deterrent insofar as borrowers have assets in play.
Ireland and Spain are stark examples here. Both saw mortgage arrears spike to double digits in the aftermath of the Financial Crisis even with far stronger recourse laws for creditors than we have in Canada.
What’s happening today
The latest data from the Canadian Bankers’ Association shows mortgage delinquencies rose to 0.27% in January…which still well below average:
What does jump out is the pace at which mortgages are going delinquent over the past 3 months. That number has surged by 1,200. You have to go back to Q2 2020 when the world locked down (and before the federally-imposed COVID “mortgage payment holiday”) for the last delinquencies have moved this sharply:
Regionally, the move is being driven by BC (+14% over past 3 months), Ontario (+12%) and Quebec (+7%). The trend in Ontario is particularly notable. We just had the highest month for new delinquencies since 2010, and we’re now seeing the largest y/y increase in arrears since the Financial Crisis.
And things may get worse yet. The latest from the Bank of Canada’s Survey of Consumer Expectations shows a high share of indebted Canadians report being at high risk of missing a debt payment over the next 3 months, including a record share in Ontario:
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-Ben R
But how can this be in Canada? Our government reminds us constantly that Canada has the lowest debt to GDP in the G7, the best economy in the G7, and they are building at a pace and speed never seen in the history of mankind.
The 2013 Journal of Finance paper is doing the heaviest analytical lift in this piece and it deserves more attention than the delinquency charts. The finding that people who know someone who defaulted are 82% more likely to declare their own intention to default is the mechanism that turns a manageable correction into a cascade — not because the fundamentals suddenly deteriorate, but because the social permission structure collapses. Ireland and Spain are the right comparisons precisely because both had strong recourse regimes that didn't prevent arrears from hitting double digits anyway, which should settle the "but Canada has recourse" argument more definitively than it usually does. The Ontario data is the thread worth watching most carefully — highest month for new delinquencies since 2010, largest year-over-year increase in arrears since the Financial Crisis, and a record share of indebted households reporting near-term payment risk all arriving simultaneously. Those aren't leading indicators anymore, they're concurrent. The mainstream financial press openly discussing strategic default as a rational option isn't just reporting on a trend — given the contagion dynamic the research describes, it's participating in accelerating it. The question Ben is implicitly raising is whether Canadian policymakers understand that the moral restraint on default is the actual load-bearing wall in this structure, and what happens when that wall starts to crack in Ontario specifically.