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.

Should we hold homeowners to a higher moral standard than businesses?

In the wake of the collapse of the housing bubble, nearly 11 million American families are "underwater", meaning that they owe more money on their mortgage than their house is currently worth. Some of these families simply can't afford to make the mortgage payments. Others can make the payments, but have decided to walk away from what is clearly a losing financial proposition. By pursuing "strategic default", these families allow banks or other lenders to foreclose on their homes and eat the loss. This allows them to seek other housing options and re-build their financial lives. While this is often a good individual financial move, not everyone agrees that it is the (morally) correct thing to do. Roger Lowenstein's interesting piece in the New York Times Magazine highlights this point:

"John Courson, president and C.E.O. of the Mortgage Bankers Association, recently told The Wall Street Journal that homeowners who default on their mortgages should think about the 'message' they will send to 'their family and their kids and their friends.' Courson was implying that homeowners — record numbers of whom continue to default — have a responsibility to make good."

Mortgage bankers aren't the only ones who feel this way. The US government similarly discourages strategic default:

"The moral suasion has continued under President Obama, who has urged that homeowners follow the 'responsible' course. Indeed, HUD-approved housing counselors are supposed to counsel people against foreclosure."

None of this should surprise anyone. Lenders want to avoid defaults because they want to get paid back. And the government is desperate to stem the tide of financial losses and prop-up the housing sector. Further, defaults create a sort of externality: if I default, I can depress the value of the houses in my neighborhood, weakening the financial position of my neighbors.

However, in many cases default is the best financial option for individual homeowners. As Lowenstein points out, businesses use strategic default in the same sort of situations. Recently, Morgan Stanley walked away from buildings it owned in San Francisco, without incurring moral outrage. In their case, it was simply business.

While it's understandable that policymakers are unhappy with strategic default, it makes no sense to hold individuals to a higher moral standard than corporations. Any coercion from government to try and get people to keep paying their mortgage is essentially a transfer of wealth from homeowners to lenders. That is not, in and of itself, a worthy policy goal.

Rather, if the government is truly concerned with the strategic default, it could try a suggestion put forth by economist Dean Baker. Baker has advocated for "The Right to Rent Plan", which would grant homeowners facing foreclosure the right to rent their home for a period of 5-10 years from the lender at the fair market rental rate. Such a policy would give borrowers and lenders an extended period to work out mortgage modifications, which would prevent the externalities imposed on communities by foreclosures. It provides a better deal for the lender (who gets revenue from the rental fees) and the borrowers (who avoid the credit impact of foreclosure). Further, this would not require government revenue, nor would it unduly reward reckless borrowers or lenders.

We all have an interest in preventing future foreclosures, but guilt is probably not the most effective policy tool to achieve this goal.

Dude, where's my catharsis?

I've just had the privilege of returning from an early screening of Choke, a movie based on one of my favorite novels of the same name. It opens September 26 and I don't want to spoil any of the film, but just urge everyone who likes laughing and does not have what they call a "sensitive constitution" to see it. 

But I'm not blogging just to make a shameless plug. Part of the preview tonight was a Q&A session with actor Sam Rockwell, director Clark Gregg and - the guy I went to see - author of the adapted book, Chuck Palahniuk. Anyone familiar with Palahniuk's work (Fight Club, Survivor, Haunted) will know that he writes about unconventional- and often taboo - communities. During the post-movie talk he explained some of his interest in these groups. 

He said that church used to be a place for open confession, "where you could be forgiven and loved for the worst part of yourself." He pointed out that often today church-going is about maintaining reputation for being good, rather than coming clean with ones sins. He argued this public bad behavior has been pushed further to the fringe to collectives such as support groups, addiction recovery 12-step programs and sex or suicide hotlines. And when it isn't expressed at all it can escalate to bouts of violence.

What he neglected to mention was the outpouring of these kind of activities online - forums and chat rooms that lend credibility and support for behavior that mainstream society, for example  cyber pranking or pro-ana Web sites. 

But the underlying point that these communities, which recognize human nature's dark side, are truly timeless. Think Roman gladiators or Mayan sacrifices. Is it true that we need to be bad? I would argue that much of what these activities accomplish in "blowing off steam" can be captured through art or athletic expression. One of my favorite examples is called flarf - deliberately offensive poetry which is particularly culled from hate speech published online. What a fantastic way to recycle harmful words and re-examine them!

Of course, Palahniuk's writing also imitates the very same underground community taboos that it satires. It's healthy to remember that every era of history has had its light and dark sides. And while Olympic competition may never replace international military conflict, attempting to master ones own demons may result in some pretty incredible art/writing/interpretive dance/gold medal record-breaking .... the possibilities are endless.