Prompted by the recent interest in walking away from bad mortgages Megan asks

We spent the last twenty years giving people a bad idea of how much debt it was safe to take on.  Now we’re giving them odd notions about the best way to get out of that debt.  Are we ever going to have a healthy relationship to credit?  Or is this just part of the American soul?

The short answer is no, we are never going to have a healthy relationship with debt. But, its not a part of the American soul. Its a part of the essential relationship between creditors and debtors.

Felix Salmon is anti-leverage. That is, he suggests equity financing is inherently inferior to credit financing. Another way of saying that is that he prefers taking on partners to borrowing money.

The reasoning is clear, in many ways creditors and debtors are inherently in opposition while equity partners are inherently on the same side. Yes, both creditors and debtors want the project, whether that’s buying a new home or expanding a business, to succeed. If it does, they both make money.

However, they don’t want it to succeed the same way. The creditor wants the sure thing. As long as the project just barely breaks even, including principle and interest payments of course, that’s just peachy with creditor. Any extra risk, any stretching for greater reward is foolhardy and to be avoided. Furthermore, should the project fail the creditor wants as modest of a failure as can be managed, so as much of the debt as possible can be repaid.

The debtor has a completely different view of things. To him a breakeven project is worthless and if the project going to loose money then who cares how much it looses. A little nothing is no better or worse than a lot of nothing. On the other hand when it comes to turning a profit, the more the merrier. If that requires taking on greater and greater risks then so be it – history (and leverage) favors the bold.

The essence of the creditor debtor relationship is that the creditor is always pushing for a more conservative approach and the debtor is always pushing to take more risk. The problem, from the creditors standpoint, is that unless their agreement explicitly forbids the debtor from taking on certain risks, the debtor can do what he wants. This is a free country and despite much public opinion to the contrary, people who lent you money don’t own you.

Why then does anyone even bother getting into this dysfunctional marriage? A couple of reasons. One, under the right conditions with the right experience and some good collateral the creditor can manage to severely limit her exposure to risk. To do this she has to be good at writing contracts, good at sizing up collateral and good at reading her borrowers. This is difficult and its why lending money is best left to professionals.

Two, credit maintains the debtors incentive to put himself fully into the project. This is a big deal when the project is mostly about the debtors effort. For example, most small business are essentially the small businessman and his tools. The business rises and falls on the debtors ability to secure good work, to establish a good reputation and to do a high quality job.

This requires enormous effort and enormous risk on the debtors part. He is putting himself out there completely. The rewards have to be high for him to be willing to do this and credit helps maintain high rewards.

For a homeowner the incentives are similar. The homeowner has enormous control over the desirability of the property. He can maintain it pristine condition and watch its value go up or he can trash it and watch its value plummet.  If he were equity partners with the bank then that would seriously diminish his incentive to keep the property in good working order.

In short, with all of its dysfunctions I think the credit financing is here to stay. And as long as it is here, lenders and borrowers will try to get the better of one another.