The Paradox of Strategic Defaults

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.

By James Kwak

34 thoughts on “The Paradox of Strategic Defaults

  1. Makes sense. But I look at it in a different way, also because I do not want to feel that I made worse/stupid decision buying the house.

    We had bought a house for $180K during the boom (mid-2006) and now it is worth $140K. But I owe only $110K on the mortgage (down and regular mortgage payments). If I would have instead opted for apartment in last 3 years, 36 months * $1000 rent = $36000.

    So basically, I have lost $4K and not $40K.

    This makes me feel good and little bit rational.

  2. You can bet after our interest only loan resets we will walk in a new york minute.. Do you honestly believe the 17 percent number? Non-recourse loan, Inland empire and bought at the top. No way in a blue moon will we stick it out.. Trust me.. The number of walk aways will be much higher. We can more than enough afford the home.. It is worth 300000 less then we bought it for. It is simple enough to buy another home with little down via the government FHA backed loans. Heck we will just buy a condo compliments of Barney Frank and this administration obsessions with homeowners… We all know a walk away will do nothing to your credit. Congress will make sure we throw out the fico scores because it won’t be fair to 1/2 of this countries folks who are in debt…

  3. Good to see some actual research in this area, but IMHO the paper raises more questions than it answers. Hopefully other researchers will pick up the baton.

    Mind you, it is very interesting that they conclude that both the Bush and Obama administrations have produced remediation strategies that assume a very low strategic default rate, based on the experience of the early 1990’s. (And both the U.K. and Australia had similar results from the same period; at that time people would do almost anything to keep their homes.)

  4. Wouldn’t one explanation be that homeowners are betting on house prices to rise again at some point in the not too distant future?

  5. If it is 17%, it shows most people arn’t too bright. But give people a few years at 10% unemployment, and they will figure out their house is sticks and stones (granite countertops), and is not worth chewing up most of their income (expecially when their “300K” tract house’s twin next door goes for 150K). Many of the people who bought recently thought it was a good “investment.” It is not, as least not at bubble era prices.

  6. What happens when neg-eq equals 100% of home value, which, by your measurement is how a 600k home that would now sell for 300k with no equity built up would be viewed.

    How does it view someone who has some arm variant where they will have a huge payment increase in some time? That person may look at what their payments will be and just decide to give up sooner rather than later.

    Does this look at speculative buyers and 2nd properties? Those buyers were counting on equity appreciation and will walk at a much more cut-throat level. These buyers were significant in 2005-2007, at least in FL, where you would see the most neg-eq homes. A ‘representative sample’ of Americans is not appropriate in this case. You really need only poll those living in FL, CA, NV, and AZ. The views on real estate and financial matters are much different, at least in FL compared to the rest of the country.

    This will be a paper that should be revisited in 3 years to assess its accuracy. People who bought in 2007 may still have a reduced payment and might be holding out for a quick rebound – see Sheila Bair’s pricing of her home to see that even people deep in the crisis can still be hopeful.

  7. 1) Many people really work their home payments as a cash flow monthly item, so the mark-to-market price of the home is not the main decision maker. If this monthly payment worked for them on the way in, they’ll keep paying to live there – in monthly terms the “deal” hasn’t changed for them.

    2) Similarly, remember some people may be paying about the same (or less) to own as they would to rent. They may not feel there’s a reason to default unless they would experience real monthly savings.

    3) Definitely some people expect prices to go back up, especially folks picturing a 10 year+ stay in the home.

  8. Clearly personal integrity is not an economic concept.

    The moment I signed a document stating that I would repay the my mortgage according to certain terms, all other considerations became irrelevant. The value of the house, switching/moving costs, whether or not I become unemployed, and even whether the loan should have been made in the first place no longer matter. I borrowed money and am honor bound to pay it back. I gave my word. The only thing that would stop me from meeting my obligation is the utter inability to do so.

    It sickens me that so many would abandon their own integrity and live their lives without honor simply based on financial considerations.

  9. Agreed.

    The underwater homeowner compares the after-tax costs of the home he or she is in, currently, with the after-tax costs of the rental he or she imagines moving to plus the psychic costs associated with moving (new schools, new neighborhood, new commuting patterns) and one’s general distaste for landlords, in general.

    There’s got to be a pretty big anticipated upside to the move before the average Tom, Dick or Harry acts.

  10. Tens of thousands of $ in sunk costs are a big psychological barrier as well. If you can afford the payment, even if you’re down $100K, it’s easy to tell yourself it will come back in your lifetime.

  11. I believe people would like to live in a dream world of integrity and honor. The government has done a grand job of discrediting the saying “what comes around goes around”.. Everyday we lose an honest person to the dark side as we watch the government bail out the most irresponsible homeowners around. The obsession with “keeping people in their homes” has virtually killed any hopes of integrity and honor when it comes to paying debts.

  12. I’m generally in the “stay” rather than “bail” camp of commentors, mainly because I think there are factors besides the simple math. I would imagine in many areas of the country renting and owning aren’t a 1-for-1 swap. Where do you park your 3 cars, boat, etc in an apartment? Your house probably had 4 BRs, your apartment 3. Do you have kids? Leaving a house for an apartment entails a whole raft of lifestyle changes to go along with it. Many people won’t give up the whole package even if the math looks better.
    Secondly, if sane lending standards ever return, I would hope that nobody who walked on a negative-equity loan could EVER get a penny of consumer credit again. After all, except for your house, EVERY consumer credit transaction is negative equity.

  13. It also depends upon which state you live in. I’m sure that in states that prohibit deficiency judgments for the unpaid mortgage balance (send the bank the keys and you’re out free and clear) the walkaway rate is much higher. Having other assets besides the upside-down house, I prefer to keep making the mortgage payments in the belief that values will rebound over time. And anyone who gets through this period without defaulting on a mortgage should get 100 added to their FICO score for life.

  14. What the government does or doesn’t do is irrelevant. Whether bankers are greedy is irrelevant. Whether “what goes around comes around” or not is irrelevant. If you borrowed the money, you are duty-bound to pay it back as you agreed to.

    Integrity has nothing to do with what others are doing.

  15. “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.”

    Or people are more honest and honorable than economists assume. Whether honoring their contract is rational or not depends upon their values. This confounding of a narrow utilitarian viewpoint with rationality by economists is a detriment and a danger to society.

  16. Or, as Shakespeare might have said:

    The second thing we do, let’s kill all the economists. ;)

    Just kidding, folks.

  17. I think more Americans would be sympathetic to this argument if the corporation (e.g. the legal corpus) was held to this same sense of honor and integrity as individuals.

    In other words, in contracting with a large corporation, most Americans are willing to show that company exactly as much honor as it shows to them.

    Which is precisely as much honor as is in their legal self-interest to display. If you want people to behave ethically, then stop supporting a system which encourages people to behave in their narrow legal self-interest.

  18. One should also take into account the option value of holding onto the home at a possibly low 30 year interest rate.

  19. i, too, am not advocating “jingle mail;” however, when we the people forgave (more like gave) $17.5B (yes, that’s BILLION) of Chrysler’s obligation, i suspect some folks equate walking to getting their piece of the action. even if we have to pay for the rest of our lives. . .

  20. What a ridiculously tired line of reasoning- it always seems to come up in a discussion of strategic defaults, and it is always wrong.

    My suggestion: read a f*&%ing mortgage contract sometime before moralizing. Any such contract will clearly state that you have two options: 1) Continue making payments and continue to occupy the house. 2) Stop making payments and return the house to the lender.

    In case you haven’t gotten it yet: defaulting and returning the property is part of the damn contract…

    End of rant.

  21. The last line is what really makes economics, and especially forecasting, so treacherous: The broad public cannot be counted on to make (mathematically) rational decisions. Come on, James, you know this. Even at the level of a well informed Congress, rational decisions are rarely made. This is why, although I have questions about him, I believe that the President is the single most rational, pragmatic politician that we have seen in some time.

  22. It is not ‘just’ economic rationality; I feel I made a promise to the bank to pay x per month for n months; and it would be reneging on my promise; as long as I can pay (especially since I have a fixed-rate, and still have my job :) I’ll keep paying my mortgage, regardless

  23. StatsGuy: “I think more Americans would be sympathetic to this argument if the corporation (e.g. the legal corpus) was held to this same sense of honor and integrity as individuals.”

    The corporation is designed on purpose to have limited liability and, hence, limited responsibility. It is a powerful, amoral entity, granted the full rights of personhood, for which a fine is just the cost of doing business.

    “In other words, in contracting with a large corporation, most Americans are willing to show that company exactly as much honor as it shows to them.”

    I. e., zip.

    “Which is precisely as much honor as is in their legal self-interest to display. If you want people to behave ethically, then stop supporting a system which encourages people to behave in their narrow legal self-interest.”

    We do need to rethink the idea of the corporation.

  24. Bayard: “The last line is what really makes economics, and especially forecasting, so treacherous: The broad public cannot be counted on to make (mathematically) rational decisions.”

    There is a group of people who rationally calculate what’s in it for them in all aspects of life: sociopaths. Perhaps economic forecasting would work out better if we only had more sociopaths in society. ;)

  25. This is rationalization at its worst. The name of the “f*&%ing mortgage contract” you’re discussing is the “Promissory Note.” It is, at its core, a promise to pay back the loan. The fact that the lender has contractual rights in the event that you don’t pay the loan back was never intended to be a put option on the value of the house, and you know it.

    I’m not talking about what is legal. I’m talking about what’s right. Too many people now can’t even tell the difference.

    Personal integrity doesn’t rely on the integrity of counterparties. In any event, in the case of a mortgage, the lender essentially lived up to their end of the deal by providing the cash in the first place.

  26. As a lender, is it less “sociopathic” to make someone perform on a contract (which is obviously detrimental to that person) than, as a borrower, walking away from that contract?

  27. I brought up the specter of the sociopath to emphasize that it’s not really a question of rationality.

    As anon pointed out, walking away from the house is an option in the contract, and the lender cannot force payment under the original terms. Neither walking away nor holding someone to their contract, even to their detriment, is sociopathic, per se. Sociopaths are not just selfish, they are dishonest and without conscience.

  28. I assume you also paid mortgage for those 36 months. That 36k is approximately equivalent to your mortgage payments, so I’m thinking you really did lose the whole 4k

  29. What’s the honor in a starving family? If you can’t pay for the mortgage, you can’t pay for the mortgage. You give the house to the bank and you rent something you can afford.

    If you are unemployed, the virtue of humility is as important as the virtue of honor.

  30. In looking at the data, I think we should consider normal patterns for home ownership. People will sell their house when they move, often for employment related reasons. These things take time to develop, so we could be severely underestimating the amount of strategic foreclosure. The marginal cost of holding onto a property which is relatively low since you realize the vast majority of the loss upon the sale of the home. If people are moving anyway for job reasons, the social and transition costs diminish and there would be reason to default in anticipation of the move.

    With prices likely to remain depressed, I would expect elevated foreclosures to remain high. It takes a while to dig your way out of large negative equity.

  31. We’re talking about strategic defaults, not those caused by true inability to pay. Please read the post and comments more carefully before spouting off.

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