Forgiveness Formulas

Copyright, The New York Times Company

In an ideal world, collecting debts would be as simple as asking debtors to pay their obligations when they are able to. But in reality most businesses have found that they need to obtain other assurances, such as collateral or the option to shut off services to a delinquent payer. Otherwise it is too easy for debtors to claim hardship and walk away without paying.

On the other hand, many families and other debtors do experience genuine hardship. In those cases it can be compassionate and even efficient to at least partly forgive the debts of people who have fallen on hard times. Many economists see loan defaults as (sometimes) an efficiency-enhancing form of risk-sharing.

Even the most hard-hearted lender may choose to partly forgive loans because too much lender effort is required to elicit full payment. Just as you cannot squeeze blood from a stone you cannot get much revenue from someone who does not have it.

One approach would be for lenders to develop and disclose a “forgiveness formula” that would clearly define “hard times” and indicate precisely what kind of forgiveness is possible. The advantage of forgiveness formulas is that distressed borrowers can be certain where they stand with the lender and can readily evaluate whether they were treated “fairly.”

Forgiveness formulas are also consistent with the idea that agreements should be clearly specified in writing, so the parties to the agreement fully understand each other and never have to argue about what the agreement really meant. Carefully specified written agreements are sometimes found in employment relationships, tenant-landlord relationships and even marriages.

This is the approach that the Federal Deposit Insurance Corporation took during the George W. Bush administration to restructure home mortgages that had fallen under water (that is, when home prices had fallen so much that selling the home would no longer provide enough proceeds to pay the mortgage in full). Borrowers were told what new mortgage terms would be affordable and under what net-present-value conditions those terms should be considered acceptable to lenders.

The clarity of forgiveness formulas is also their weakness, because they make it easier for debtors to “game the calculation” and can ultimately make loans more costly for borrowers who pay in full. The Internal Revenue Service has long been secretive about its procedures for auditing returns and restructuring delinquent tax payments, and the Treasury maintained that approach when it became involved with restructuring home mortgages (the Congressional Oversight Panel discusses this matter on Page 41 of this report).

Hospitals are also known to partly forgive medical debts incurred by the uninsured, while they make no accommodation for many others. Some states require hospitals to explain in writing how they go about discounting charges for hardship patients (as we can see in New York’s policy), but you might guess that hospitals worry that patients will game those calculations in order to pay less.

One advantage of health reforms that get more people on health insurance is that by getting people to pay for their health care before they get sick, the reforms reduce the number of cases in which clear forgiveness has to be traded off with formula gamesmanship.