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Why Does Anyone Pay Off Debt?

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Debt has become such an important feature of so many aspects of our lives that it is worth expending a bit of effort on understanding the basic operations of debt.

So today let’s look at the question: why does anyone repay their debt?

This might seem like a dim question. People repay their debts because they made a repayment promise when they borrowed money. They incurred a duty—legal and moral—to make payments according to a repayment schedule. The lender only agreed to extend the loan on promise of this repayment.

But there’s something a bit thin to this way of looking at things. It no doubt explains a lot about why we repay our debts in good times.

But when times are tough, often our obligations to our creditors interfere with other legal and moral obligations—such as providing for our families, or even paying off other debts.

To put it a bit abstractly, in a world of unlimited abundance, the choice to pay off debt is obvious and easy. In a world of scarce resources, it is more difficult. So the question really is why we choose to meet certain obligations rather than others?

It helps to think about debt not a single loan and repayment transaction—but as a series of purchases. The lender purchases a promise to pay—and perhaps security rights in collateral—in exchange for a special kind of payment called a loan. The borrower purchases back this promise to pay—and perhaps security rights in collateral—with a special kind of payment called a “repayment.”

What Is a Mortgage?

When you take out a mortgage, for example, you are really selling something to the bank—security rights in your home and your promise to pay the loan back with interest. When you make payments on your mortgage, you are working toward the total repurchase of those security rights on an installment plan. While you are making those payments, you are also purchasing the right to continue to reside in your home. Eventually, you pay off your mortgage and complete the repurchase of what you sold to the bank.

But it is not just residency and the security interest you are purchasing, you are also purchasing optionality of various sorts. You are purchasing the right, for instance, to default on your loan later if home prices drop too far. In limited recourse states, you are purchasing the right to put future losses to your bank. You are also purchasing the right to the future gains on your home if prices go up.

Finally—and importantly—you are purchasing your access to the loan market in the future, knowing that if you default, obtaining future loans will be very difficult.

From this example we can see why the present situation—falling home prices, increasingly restrictive mortgage lending, and interest rates likely to rise—is not promising for mortgage repayment. The value of future gains looks increasingly diminished. The price of residency through mortgage payments versus renting is no longer as favorable.

The already steep decline in prices makes it tempting to realize the value of the put option on your home. And, importantly, access to credit markets may already not exist if you are a subprime borrower with a poor credit score.

Muni Bonds?

If we understand why people do and do not pay off collateralized debt such as mortgages, we need to ask: why does anyone pay off non-recourse debt? If you cannot force a borrower to repay, why should you expect him to repay?

This question is especially important when it comes to municipal bonds. A huge portion of muni debt is not really secured by anything except a promise to pay. The bondholder has simply purchased a promise of payments. What is the bond issuer buying by making payments?

The answer seems to be: access to credit markets. The bond issuer makes payments not principally because he borrowed in the past—but because he plans to borrow in the future.

Once we understand that municipal debt payments are purchases of a good, we can better understand the likelihood of municipal debt defaults. The chances of default are dependent on the relative marginal value of access to credit markets compared to the marginal value of other goods—such as pension and healthcare benefits, education, highways, bridges and social services.

Importantly, this marginal value calculation is not an objective one that can be made in the abstract. It is the subject marginal value of the decision makers. Less abstractly, it is the value to the politicians who must make decisions about where to cut their budgets.

Will it be pensions and healthcare or bonds? Which do they value more: the support of the pensioners or access to credit markets?

A lot of bullishness on muni bonds depends on the idea that access to credit markets is very valuable. But there is surely some limit to its value. If the price in terms of other goods foregone becomes too steep, some politicians will prefer to default.

A Reversal of Values

In short, credit markets are better understood as purchase transactions in which lenders and borrowers exchange cash for goods.

Whether or not the cash is exchanged depends on the value of the goods and the opportunity costs of goods that cannot be purchased.

An aging population that is increasingly involved in influencing political outcomes could make it very pricey for politicians to cut pension and health care benefits. At the same time, rising interest rates may make credit so expensive that the value of immediate access to credit markets diminished.

When wondering when any loan will be repaid we should always ask: what is the debtor buying with his repayment?

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