Strategic Defaults: When Homeowners Walk Away From Mortgages They Can Afford

Even when a home is financially underwater (the total mortgage balance is greater than the value of the property) owners will usually make serious efforts to keep from defaulting. But only up to a point. If it gets too far underwater, people will let it go -- even if they can afford to make the payments. While there may be an intuitive sense to this, the fact is not widely recognized.

Today's "home rescue" programs – loan modifications and the like – are based on the assumption that homeowners will not default on mortgages as long as they can afford to make the payments. In many cases, this assumption may be mistaken.

The Making Home Affordable program has resulted in far fewer trial loan modifications than had been anticipated. In partial response to this disappointing fact, the administration raised the eligibility bar from a 105% loan-to-value ratio to 125%. (Suppose you had a home worth $100,000. Originally you could get a loan mod even if you owed as much as $105,000. Now the limit would be $125,000.)

There are good reasons to think that this shift in the program will not produce the desired results. This is because the further underwater a home is, the more likely that the owner will choose to default – even if he or she can afford to make the payments. These are the findings of an important paper, "Moral and Social Constraints to Strategic Default on Mortgages" by Guiso, Sapienza and Zingales. It was produced under the auspices of the Financial Trust Index (financialtrustindex.com) which has conducted extensive survey research into consumer attitudes with respect to finances and the financial system.

The authors distinguish between "strategic defaults" and what we might call "ordinary" or "forced" defaults. The latter occur when people simply can't make the payments. In a strategic default, the homeowner chooses to 'walk away' even though they can make the payments. The authors found that about 26 percent of existing defaults are strategic.

A strategic default occurs when a borrower decides not to "throw good money after bad." This cliché summarizes a prudent strategy of asset allocation. Why, indeed, might anyone ever be willing to throw good money after bad? The authors point out that, in the case of mortgages, there are both moral and social constraints at work.

Eighty-one percent of survey respondents agreed that "it is morally wrong to walk away from a house when one can afford to pay the monthly mortgage." But this view does not dictate behavior in all circumstances. Moral considerations may be trumped by financial realities. Reactions to hypothetical scenarios produced interesting results. If equity was a negative $50,000, 20% of those who think default is not morally wrong would walk away, whereas only 7% of the "moral" ones would. But, if the negative equity is increased to $100,000, 22% of the "moral" ones would. At $200,000 upside-down, 37% said they would walk even though they thought it was morally wrong.

Morality aside, there are also social constraints against walking away from a mortgage. A social stigma is attached to default, and that can be a powerful influence. But not overwhelming. As defaults become more common, the social stigma is diluted. The researchers found that "…people who know someone who defaulted strategically are 82% more likely to declare their intention to do so."

This, of course, may lead to a vicious downward spiral. As values drop, people become more willing to strategically default. More defaults lead both to a greater decrease in values and to an increased willingness to strategically default, which leads to more defaults, etc.

None of this bodes well for the future. A recent report from CNNMoney.com cites a Deutsche Bank analysis that estimates "25 million borrowers, representing 48% of all Americans with mortgage loans" will owe more than their house is worth by 2011. Other estimates have been similar, though not as extreme. Moreover, the Deutsche Bank forecast is that the percentage of borrowers underwater by 25% or more will at least double to 28% of those who are upside down. This would suggest a dramatic increase in the number of strategic defaults to come.

A possible conclusion to all of this might be that, to be effective, more loan modifications are going to require reduction of principal as well as payments. On the other hand, if principal reductions are granted in a manner that seems unfair, that might weaken the existing moral constraints against walking away.

Fixing this is not going to be easy.

Written by Bob Hunt for www.RealtyTimes.com Copyright © 2009 Realty Times All Rights Reserved.