Finance & Accounting Strategy Economics Policy Jul 1, 2009

Walk­ing Away

Moral, social, and finan­cial fac­tors influ­ence mort­gage default decisions

Based on the research of

Luigi Guiso

Paola Sapienza

Luigi Zingales

The mort­gage cri­sis that start­ed in 2007 pre­cip­i­tat­ed an unprece­dent­ed fall in the val­ue of Amer­i­can hous­ing. The num­ber of house­holds that owe more on their mort­gages than the val­ue of their homes has great­ly increased; for some regions that fig­ure exceeds 50 per­cent. Over­all, more than 20 per­cent of house­holds in the Unit­ed States now have neg­a­tive equi­ty. This has led to a new phe­nom­e­non: strate­gic defaults. These occur when home­own­ers walk away from mort­gages that exceed the val­ue of their hous­es even when they can afford the month­ly payments.

The like­li­hood of strate­gic defaults has a crit­i­cal impact on gov­ern­ment efforts to alle­vi­ate the prob­lem of neg­a­tive equi­ty and its effect on the over­all econ­o­my. Unfor­tu­nate­ly, few tools exist for deter­min­ing why and how often house­hold­ers choose or refuse that option. The Oba­ma admin­is­tra­tion has ref­er­enced a paper pub­lished last year in the Jour­nal of Urban Eco­nom­ics by Christo­pher Foote and col­leagues at the Fed­er­al Reserve Bank of Boston. Dur­ing the 1990 – 1991 reces­sion in Mass­a­chu­setts, they found that very few peo­ple who could afford their mort­gage pay­ments walked away from their hous­es. How­ev­er, only 6 per­cent of bor­row­ers had neg­a­tive equi­ty at the time. Fur­ther­more, the amount of neg­a­tive equi­ty did not exceed 10 per­cent. Today’s fig­ures great­ly exceed both numbers.

Now, a study co-authored by Pao­la Sapien­za (Asso­ciate Pro­fes­sor of Finance at the Kel­logg School of Man­age­ment) pro­vides valu­able new insights for pol­i­cy­mak­ers. Its con­clu­sions: The pace of strate­gic defaults quick­ens as the amount of neg­a­tive equi­ty increas­es beyond 10 per­cent of a home’s val­ue. But moral and social con­sid­er­a­tions play a cru­cial role in dis­suad­ing many house­hold­ers from tak­ing that route — at least until poten­tial loss­es reach a cer­tain threshold.

A Bet­ter Pre­dic­tion
We’re try­ing to for­mu­late a bet­ter pre­dic­tion at the high range of loss­es,” Sapien­za explains. We ask the ques­tion: If a home­own­er has neg­a­tive equi­ty in his house and can still afford to pay, what is the prob­a­bil­i­ty he will walk away from the house? If the final answer is that strate­gic default is unlike­ly, then the right approach is to dis­re­gard this prob­lem in design­ing poli­cies. Alter­nate­ly, if the answer to the ques­tion is that many home­own­ers are like­ly to walk away, then it is impor­tant for the Oba­ma admin­is­tra­tion to seri­ous­ly con­sid­er the social and eco­nom­ic con­se­quences of this behavior.”

Walk­ing away from an afford­able mort­gage with neg­a­tive equi­ty has cer­tain dis­ad­van­tages. In addi­tion to los­ing a home cus­tomized to their tastes, depart­ing house­hold­ers incur relo­ca­tion costs and suf­fer severe reduc­tions in their cred­it rat­ings — mak­ing it dif­fi­cult for them to bor­row in the future. And most states allow mort­gage hold­ers to pur­sue strate­gic default­ers for the dif­fer­ence between the amount owed on the mort­gage and the house’s resale value.

Despite those fac­tors, Sapien­za says, It’s rel­a­tive­ly easy to walk away in the Unit­ed States.” How­ev­er, she con­tin­ues, Econ­o­mists won­der whether mon­ey is the only consideration.”

In col­lab­o­ra­tion with Lui­gi Guiso (Pro­fes­sor of Eco­nom­ics at the Euro­pean Uni­ver­si­ty Insti­tute) and Lui­gi Zin­gales (Pro­fes­sor of Entre­pre­neur­ship and Finance at the Booth School of Busi­ness, Uni­ver­si­ty of Chica­go), Sapien­za set out to quan­ti­fy the impact of non-finan­cial con­sid­er­a­tions on mort­gage default deci­sions. Indi­vid­u­als may have moral con­sid­er­a­tions that affect their will­ing­ness to default,” the team writes in a work­ing paper. Default can be per­ceived as moral­ly wrong and, as such, some­thing to avoid — if not at all costs — at some sig­nif­i­cant cost. Moral con­sid­er­a­tions, if wide­spread, may strong­ly mit­i­gate the like­li­hood that Amer­i­can house­holds will default on their mort­gage, even if the val­ue of hous­ing con­tin­ues to depreciate.”

Dri­ving Strate­gic Defaults
To study the con­straints on strate­gic mort­gages, Sapien­za for­mu­lat­ed a sur­vey to col­lect rel­e­vant infor­ma­tion from 1,000 rep­re­sen­ta­tive Amer­i­can house­holds. Called the Chica­go Booth — Kel­logg School Finan­cial Trust Index, it tracks changes in trust in the finan­cial indus­try and its impact on investors’ deci­sions, with updates pub­lished quar­ter­ly. Con­duct­ed in Decem­ber 2008 and March 2009, the sur­vey includ­ed ques­tions regard­ing strate­gic defaults: How like­ly are you to under­take a strate­gic default if your home’s val­ue falls short of the mort­gage loan you owe by var­i­ous amounts? And, do you regard a strate­gic default as moral­ly wrong? To guage the social pres­sures on home­own­ers, respon­dents were also asked how many peo­ple they knew who had default­ed on their hous­es and how many had default­ed strategically.

The sur­vey reveals three main influ­ences on the 26 per­cent of all defaults that, accord­ing to acquain­tances, are strate­gic. Where­as only 5 per­cent of house­holds would default strate­gi­cal­ly if they faced a short­fall between 10 and 20 per­cent of the val­ue of their homes, the num­ber ris­es to 17 per­cent for a short­fall of 50 per­cent. Even the 81 per­cent of respon­dents who think it moral­ly wrong to default on a mort­gage when one can afford to pay it can change their minds when their poten­tial loss­es increase. In addi­tion, the authors report, 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.” Oth­er things being equal, the researchers con­tin­ue, Peo­ple who con­sid­er it immoral to default are 77 per­cent less like­ly to declare their inten­tion to do so, while peo­ple who know some­one who default­ed are 82 per­cent more like­ly to declare their inten­tion to do so.”

We con­firm the Foote paper’s con­clu­sion that below 10 per­cent neg­a­tive equi­ty peo­ple do not walk away, as it is too cost­ly and there is a moral con­sid­er­a­tion — a shame fac­tor,” Sapien­za sum­ma­rizes. Our con­tri­bu­tion is to show what may hap­pen when the drop in val­ue is greater than 10 per­cent. In areas where the ratio of fore­clo­sures to total mort­gages is more than 15 per­cent, peo­ple are more inclined to walk away. When neg­a­tive equi­ty is large enough, peo­ple declare that they would walk away from their mort­gage. Peo­ple who think it is immoral are still less inclined to do so, but from our sur­vey we learned that when eco­nom­ic con­sid­er­a­tions are large enough they mit­i­gate moral constraints.”

Pol­i­cy Impli­ca­tions
What does the study imply for pol­i­cy­mak­ers’ efforts to ease the mort­gage cri­sis? We don’t have a pol­i­cy rec­om­men­da­tion,” Sapien­za says, but we assert that the per­cent­age of peo­ple who may decide to walk away because of the sub­stan­tial col­lapse in house pric­ing is not triv­ial. It could affect addi­tion­al peo­ple in the com­mu­ni­ty. Pre­vi­ous stud­ies did not reveal that problem.”

The research also reveals that local­i­ties need to fine-tune their respons­es to the cri­sis accord­ing to the extent of hous­ing val­ue loss. It gives us bet­ter knowl­edge of what will hap­pen in areas where prices have dropped by 40 per­cent, say, com­pared with areas in which the decrease in prices is not so high,” Sapien­za points out.

Final­ly, the study con­tains a mes­sage for home­own­ers who have kept up their mort­gage pay­ments and who might resent the idea of gov­ern­ment sup­port for those who have not. At some fun­da­men­tal lev­el I could be upset that the gov­ern­ment comes in to help my neigh­bor with bailout mon­ey that comes from my tax­es,” Sapien­za says. But I am more like­ly to accept gov­ern­ment inter­ven­tion if I real­ize that oth­er­wise many of my neigh­bors might walk away, caus­ing the val­ue of my own house to decline further.”

Fur­ther reading:

Foote, Christo­pher L., Kristo­pher Ger­ar­di and Paul S. Willen (2008). Neg­a­tive equi­ty and fore­clo­sure: The­o­ry and evi­dence.” Jour­nal of Urban Eco­nom­ics, 64(2): 234 – 245.

Wible, Brad (2009). Mea­sur­ing Trust. Intro­duc­ing the Finan­cial Trust Index (Based on the research of Pao­la Sapien­za and Lui­gi Zin­gales)” Kel­logg Insight, February.

Featured Faculty

Paola Sapienza

Donald C. Clark/HSBC Chair in Consumer Finance, Professor of Finance, and Zell Center Faculty Fellow

About the Writer

Peter Gwynne is a freelance writer based in Sandwich, Mass.

About the Research

Guiso, Luigi, Paola Sapienza, and Luigi Zingales. Forthcoming. “The Determinants of Attitudes Towards Strategic Default on Mortgages,” Journal of Finance.

Read the original

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