Sunday, January 24, 2010

Social Norms and Strategic Defaults

Richard Thaler has some interesting analysis of why more underwater homeowners don't simply default on their mortgages. As I've written before, social norms play a large role. This was particularly interesting:
The morality argument is especially weak in a state like California or Arizona, where mortgages are so-called nonrecourse loans. That means the mortgage is secured by the home itself; in a default, the lender has no claim on a borrower’s other possessions. Nonrecourse mortgages may be viewed as financial transactions in which the borrower has the explicit option of giving the lender the keys to the house and walking away. Under these circumstances, deciding whether to default might be no more controversial than deciding whether to claim insurance after your house burns down.

In fact, borrowers in nonrecourse states pay extra for the right to default without recourse. In a report prepared for the Department of Housing and Urban Development, Susan Woodward, an economist, estimated that home buyers in such states paid an extra $800 in closing costs for each $100,000 they borrowed. These fees are not made explicit to the borrower, but if they were, more people might be willing to default, figuring that they had paid for the right to do so.
Of course, if people were more likely to default, then the implicit costs would be higher than the $800 estimated by Susan Woodward. Still, many homeowners are continuing to make mortgage payments at a loss, and it would be interesting to see how they behaved if they felt they already paid fees to cover the risk of default.

1 comment:

Salty American said...

Came across your blog via the "next blog" button. Good content here.

My comment here is that the "default insurance" you cite in nonrecourse states was most likely charged based on historical norms for defaults and home values. If articles like Thaler's continue to encourage people to walk away from their mortgages, it's possible that would create the need for another TARP program.