The Paradox of Strategic Mortgage Defaults

By James Kwak

Real Time Economics and Calculated Risk both discuss new research by Paola Sapienza, Luigi Zingales, and Luigi Guiso on homeowners defaulting on mortgages even though they have the money to pay them. According to their research, 17% of households would default when their negative equity reaches 50% of the house’s value. The argument is that public policy has not sufficiently addressed this problem, focusing instead on homeowners who cannot afford their mortgages.

Let’s make this a little more concrete. Let’s say you bought a house with zero money down for $300,000 in early 2006. A few years later, the house is now worth $200,000, so your negative equity is 50% of the market value. Yet only 17% of people in your situation would walk away from the house. The other 83% would continue to pay the mortgage, essentially throwing money away. Apparently people value the transaction costs of moving and the damage to their credit ratings at $100,000 (I think my numbers are approximately on the right scale – if anything they are probably low) – even after the fact that you can live in a house for free for several months before being evicted.

Or people are not as rational as economists would assume.

Comments

[speeddaimon:]

Is it possible that people just assume that house prices will go back up sooner or later, and if they're not interested in moving, and are happy where they are, that paying on an underwater mortgage for a year or two makes sense?

Jun 29 03:39 PM

[D_Virginia:]

Right: if you are comfortable with your payments and are happy in your house, you have no major incentive to move (and eat the credit hit, etc).

But if you have a life event that drives the move, such as a marriage, divorce, job change, etc, or if your payments go up such that they are no longer comfortable, then you probably won't think twice about leaving a significantly underwater property, as long as you can escape the banks' wrath -- which, in many states, you can't.

Jun 29 04:24 PM

[nobby73:]

If individuals thought and acted like banks, they would walk away, because the economics dictate behaviour. However, the majority of Americans are decent, morally upright people who don't behave like most politicians or corporation and feel they have a moral obligation to keep their promises. However, therein lies the paradox - they are blind to just how anti-social and mendacious most corporations and are.

Jun 29 04:57 PM

[Gtarras:]

i guess it also depends on what your rent would be... i also remember that when the govt came out with the proposal to limit the refi options to LTV<105% folks only, that cited a similar study from Boston area in early 90s that claimed that the "strategic default" rate was only 6%...


On Jun 29 04:24 PM D_Virginia wrote:

> Right: if you are comfortable with your payments and are happy in
> your house, you have no major incentive to move (and eat the credit
> hit, etc).
>
> But if you have a life event that drives the move, such as a marriage,
> divorce, job change, etc, or if your payments go up such that they
> are no longer comfortable, then you probably won't think twice about
> leaving a significantly underwater property, as long as you can escape
> the banks' wrath -- which, in many states, you can't.

Jun 29 05:49 PM

[bigmoney:]

maybe a single man would be "rational", but the man with wife and children ...

Jun 29 11:57 PM

[OptimizedPrime:]

@bigmoney -- The "rational" man with a wife and kids will want better schools for his kids, more room for mom and more money every month for the whole family. In other words, a few weekend's work in moving down the block into a rental (maybe somebody else's walk-away) or maybe across town to the better schools will improve their lives.

@Gtarras -- The Boston study wasn't done in an environment like this. Unlike back then, today smart people who read the papers know that their home is NEVER EVER going to return to the price they bought it. Back in Boston at the time people didn't have the macro factors to ponder. Now they do. Back then they might have considered that they might want to buy someplace else. Now it makes no difference.

I personally think that "strategics" are going to be a BIG problem...


OP

Jun 30 04:06 AM

[speeddaimon:]

"Unlike back then, today smart people who read the papers know that their home is NEVER EVER going to return to the price they bought it"

That really depends on a large number of factors. I mean, if someone bought a house in 2004 (in the middle of the housing boom, but far from the top) I'm willing to bet their value will return eventually. People that made the unfortunate mistake to buy in late 2006 (like myself) in a hot market like LA, Phoenix, Vegas, Florida, etc, willl most likely have to wait 15 years before their house has any equity whatsoever.

I do, however, agree with the rest of what you wrote.


On Jun 30 04:06 AM OptimizedPrime wrote:

> @bigmoney -- The "rational" man with a wife and kids will want better
> schools for his kids, more room for mom and more money every month
> for the whole family. In other words, a few weekend's work in moving
> down the block into a rental (maybe somebody else's walk-away) or
> maybe across town to the better schools will improve their lives.
>
>
> @Gtarras -- The Boston study wasn't done in an environment like this.
> Unlike back then, today smart people who read the papers know that
> their home is NEVER EVER going to return to the price they bought
> it. Back in Boston at the time people didn't have the macro factors
> to ponder. Now they do. Back then they might have considered that
> they might want to buy someplace else. Now it makes no difference.
>
>
> I personally think that "strategics" are going to be a BIG problem...
>
>
>
> OP

Jun 30 11:06 AM

[snagglesnarf:]

This is the situation I am in right now in California. I have a $300,000 mortgage on a house now worth about $230,000 and falling. I could take my retirement money and pay cash for a similar home and then apply the $500,000 or so that I would save on principal and interest to easily replenish my retirement fund. I feel like an idiiot for not doing this but there is still something in me that wants to preserve my good name and reputation. These are strange times.

Jun 30 07:15 PM

[RatWatcher:]

Although the example assumes 0% down, the research cited in the first part of the article doesn't appear to. I would guess there is a big difference in walking away from a $0 down (or any low-down, such as FHA or VA) as opposed to walking away when the owner has invested a substantial down payment. Something in the psyche about losing the downpayment, even after it is already (at least temporarily) lost? Kind of like riding a loser stock all the way down, not wanting to admit the mistake and realize the loss?

Also of import, which I mention since I don't see in the current comments, is whether the home is in a 'recourse' or 'non-recourse' state. Not sure if the research took that into account. You don't walk away from a mortgage you can pay, if you have other assets that can be attached.

Jul 05 10:28 PM