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.

Arnold Kling on the housing collapse

In a very wise move, Congress has asked Arnold Kling to testify about the housing crisis and the crater is has left in financial markets. Kling posted his planned remarks on his blog. He has a much more nuanced understanding of the crisis than many of the louder voices out there:

Speaking as a former financial engineer, I have many regrets about the role played by modern financial methods in this crisis. Rather than speak defensively about financial innovation, I want to offer constructive suggestions for public policy going forward.

I emphatically disagree with the extreme partisan narratives for this crisis. To blame the Community Reinvestment Act for what happened is wrong, To blame financial deregulation for what happened is wrong. The narrative I present in my written testimony describes a combination of government failure and market failure.

I want to focus on how both industry executives and regulators were fooled about the risks in the system. In particular, perverse incentives in bank capital requirements encouraged unsound lending practices and promoted excessive securitization.

Kling also offers 4 lessons from the crisis:

1. Capital requirements matter. Details that are easily overlooked by regulators can turn out to cause major distortions.

2. Securitization is not necessary for mortgage lending. On a level regulatory playing field, traditional mortgage lending by depository institutions probably would prevail over securitized lending. Rather than try to revive Freddie Mac and Fannie Mae, I would recommend that Congress encourage a mortgage lending system based on 30-year mortgages originated and held by old-fashioned banks and savings and loans. This would require instructing the regulators of Freddie Mac, Fannie Mae, banks, and savings and loans to all use the same capital standard for mortgages, one that is based on a stress test methodology.

3. Subsidized mortgage credit is an inefficient tool for promoting home ownership. Unless what you want is home buyers who are buried in debt and speculating on house price appreciation, I recommend that Congress not try to create cheap mortgages and instead use other means to encourage home ownership.

4. Recent financial innovations, particularly credit default swaps, have changed our financial system in ways that current policymakers fail to recognize. Bailouts and rescues are counterproductive in today's financial crisis. Within the financial sector, de-leveraging needs to slow down and the process of shutting down failed institutions needs to speed up. Relative to these necessities, handouts from the taxpayers are a hindrance, not a help.

Definitely read the whole thing.

Should we prop-up the housing market?

Given the current crisis, it seems natural for Congress to want to prop-up housing values in order to prevent further losses of wealth. But according to Harvard economist Ed Glaeser, this could be ineffective at best, and would likely be counterproductive:

"One of the clearest lessons of the past year is that these lending policies are anything but cheap. To get banks to lend at below-market rates, the government must insure mortgages against default. When those mortgages do default, as they have in droves over the past two years, taxpayers are on the hook. Ordinary taxpayers are currently facing the prospect of paying for the last rash of government-subsidized lending. No one should be thrilled at the idea of a new government guarantee program that makes us liable for billions, or trillions, of dollars of new, bad mortgages...

In fact, the government shouldn't really be in the business of making housing more expensive at all. Price supports are usually a bad idea, because they distort supply decisions and redistribute from buyers to sellers. Why, exactly, should the government be encouraging more overbuilding in Las Vegas? Why, in an age of global warming, should the government subsidize more McMansions? Some economists argue that price supports are needed because prices are below fundamentals, but prices today remain significantly higher than either historical norms or supply costs."

As right as we are to blame the financial crisis on the baffling decisions made on Wall Street, we shouldn't ignore the long history of government policy designed to encourage home buying, which exposed taxpayers and the financial system to an enormous amount of risk.

Additionally, much of the environmental critique of the American landscape is the direct result of conscious public policy efforts, as described above.