Today, there are demonstrations in Barcelona and across Spain against "the political class, the crisis, and the fact that people who lose their house because they can't pay the mortgage still owe something to the banks..." or so my cabby explained. The last bit is interesting. Dación en pago, the idea that someone who borrows on mortgage can just hand back the keys, has become the fantasy of many Spanish house buyers who are faced with negative equity. In the US, this happens a lot; many states allow the practice. In almost all European countries, including Spain, it's a no-no.
So who is right? It's actually not very hard to think through the consequences. Allen and Gale have a beautiful paper that looks at exactly this kind of thing. It's called "Bubbles and Crises". The idea? If you have a "stupid" bank that, on average, loses money, its lending is likely to create bubbles galore. The reasons is risk-shifting. If you borrow to buy an asset, and it goes up in value - bingo, you are rich. If it goes down, you just hand it back to the bank. Since none of your money is at risk, you can't lose. How much of that asset do you want to buy? Me personally, a lot. Sign me up. Actually, double that. And so on. Of course, this creates price pressure upwards... The downside of the model was that it required a stupid bank that lost money on average. But if there is one thing we have learned in the last 10 years, it's that there is no shortage of stupid banks. So, while handing the keys back to the bank and cancelling all debts sounds nice ex post for those who got themselves mortgages that were too big relative to their incomes, it is really, really bad policy. The depressing thing, of course, is that given how loud vox populi is, it is not impossible that someone somewhere will want to garner some votes by changing the rules.
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