Market Update – March 19, 2010 — Strategic Default

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A couple of weeks ago, I saw reference to a paper involving the idea of “strategic default” – where people walk away from their home because it’s underwater, even though they can afford the payment.  I spent a couple of hours today reading the paper.  This is a really important issue.  We have no idea of what will happen in the home market when the tax credit expires and the Fed stops buying mortgage backed securities.




The paper is titled, “Moral and Social Constraints to Strategic Default on Mortgages,” and it’s written by Luigi Guiso (European University Institute), Paola Sapienza (Northwestern) and Luigi Zingales (Chicago).  I limited the time that I spent with the paper.  So please realize that I’m trying to look at the intuition (not necessarily what is statistically significant in the findings).




The focus of this paper was to understand how likely homeowners are to default when they are underwater and what factors drive this decision.  This is difficult information to gather and was done by survey.  Obviously, this isn’t perfect.  But, this paper raises important issues and can supply us with valuable intuition.




Here’s a summary of the important points from this paper:

1. Foreclosures results in lower home prices.  Prior research by Campbell et al. (2009) indicates that forced sales due to foreclosure sell at a 28% discount on the house’s value.




2. Strategic default is an option for most people (even if they have assets). Even though very few states have mandatory non-recourse laws (where the lender can’t sue the borrower for the difference between the value of the foreclosed property and the loan), most lenders don’t go after borrowers because of the cost involved.




3. Being underwater is certainly not a guarantee that a homeowner will walk away.  First, homeowners must be significantly underwater to consider this action.  If a homeowner is only slightly underwater, there are several economic factors that dissuade a borrower from defaulting, including: the cost of alternative lodging, relocation costs, injury to credit rating and risk of losing other assets (if this is a recourse loan).  You would also expect that people are less likely to walk away if they have more kids (may have to change schools) or they have remodeled.




4. If you look at the percentage of people who are willing to strategically default based on the amount that the homeowner is underwater as a percentage of the home value, no one declares their intent to strategically default if they are less than 10% underwater.  Approximately 5% of homeowners are willing to default if they are from 10% to 20% underwater and the number reaches 17% when the shortfall reaches 50%.

In general, price drops of less than 20% do not lead to many strategic defaults. If you think about median home prices and the fact that most people won’t walk away for less than $50K, this makes sense.




5. The likelihood of strategic default increases with the amount of negative equity:

$50K – 9.38%

$100K – 25.81%

$200K – 41.23%

$300K – 44.65%




6. The strongest relationships between walking away and economic factors were the value of the shortfall as a percentage of the home value and the length of time that the person lived in the house (which may measure attachment to the house, unique remodeling done on the house and the cost of leaving).




7. Even if a homeowner is significantly underwater, there are also non-economic factors that may dissuade a borrower from defaulting, including: the idea that default may be considered morally wrong and the social stigma of defaulting.




8. 81% of people think that it’s morally wrong to strategically default.  People who think that it is morally wrong are significantly less likely to say that they would engage in such behavior.  With that said, if the amount is large enough, a large percentage of people who think that it’s morally wrong will still default! For example, if the negative equity is $200K, 37% of those people still say they would default.




9. The most important variables in determining the likelihood of strategic default are moral and social considerations.




10. The following groups are more likely to say that it’s not immoral to walk away:

- younger people (<35 years old),

- older people (>65 years old)

- more educated people

- Independents (as opposed to Republicans and Democrats)

- people who feel that the Government should help homeowners

- people who don’t expect prices to bounce back

- people who are less attached to their home




Interestingly, wealthier people are “more moral” – which is surprising since educated people are “less moral.”  Personally, I wonder if wealthier people feel like they can’t walk away (because they are more likely to be sued) and they decide that when others are walking away it is immoral.




Final Thoughts

We know that a homeowner’s belief as to the morality of strategic default is the most significant factor in determining whether they exercise this option.  We also know that people become more accepting of strategic default as people they know exercise this option.  This creates the risk of People contagion.




We rely on moral suasion to prevent contagion.  You might also be better off if you live in a neighborhood with “moral” people.  The more pressure that we put on people (the greater the stigma of defaulting), the better off you will be!
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