There’s a Case for Abandoning a Bad Mortgage

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New U of A discussion paper hits a social nerve

As the nations housing crisis enters its fourth year, the option of walking away from mortgages on over-encumbered homes is gaining social acceptance. Recently, University of Arizona law professor Brent White published a paper about the tactic of abandoning a home, (Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis, University of Arizona, Discussion Paper No. 09-35 November 2009).It isn’t the first time the idea has been brought up, and debt survival is a sensitive issue, but White’s paper and it’s conclusions may hit a nerve.

Its crowded underwater

According to First American CoreLogic, some 10.7 million Americans are presently underwater on their mortgages, meaning that their mortgage balances exceed their home values. White states:

As of June 2009, more than 32% of all mortgaged properties in the U.S. were underwater, meaning that the homeowner owed more on their mortgage than their home was worth. This percentage is expected to increase to 48% by the first quarter of 2011, by which time housing prices in the largest 100 metropolitan areas are predicted to have dropped 42% from their peak.

One in four homeowners would be better off renting

Walking away from over-mortgaged homes is a move that can save people money if theyre willing to take personal financial risks. One of those disconcerting risks, of course, is that a foreclosure remains on an individuals credit report for seven years, making it difficult to obtain new credit. Although its possible that people with otherwise good credit might begin to overcome lending hurdles sooner than that, people in general are hesitant to wreck their credit. This hesitancy is borne out by the fact that millions of people about one in four would be much better off financially if they walked away from their mortgages, and yet, they do not.

Homeowners tend to take the highroad

If all owners of over-mortgaged homes walked away, economic havoc would no doubt ensue.Home prices could take a deeper plunge, which would make bansk even MORE hesitant to lend to both individuals and businesses. Still, its odd that in the midst of a severe housing crisis, borrowers have taken the high road and struggled to honor their mortgage commitments, while the lenders that doled out high-risk mortgages in the housing boom have eagerly taken in billions of taxpayer dollars. These are the same lenders that now shamelessly resist the modification of troubled mortgages. White points out that this is a double standard involving a contradictory (READ: hypocritical) business morality.

White is a scholar of behavioral economics and law, so he knows what he’s talking about. Obviously, the norms governing borrower behavior are at odds with those of lenders. Lenders, as recently demonstrated in stark relief, seek to protect the bottom line without concern for morality or social responsibility. Wall Street gets to maximize profits and minimize losses irrespective of concerns about morality, he says.

Homeowners, on the other hand, are expected to honor their promises, however unmanageable a change of circumstance may be. This moral asymmetry, White concludes, results in a distributional inequality with homeowners bearing a disproportionate burden from the housing collapse.

Emotional constraints deter strategic defaults

White suggests that the choices of most homeowners not to strategically default are the result of two emotional constraints.First is a desire to avoid the shame and guilt of a foreclosure, and the second is exaggerated anxiety about the consequences of a foreclosure. These emotional forces, he continues, are actively cultivated by the government and other social control agents in order to encourage homeowners to follow social and moral norms related to the honoring of financial obligations and to ignore market and legal norms under which strategic default might be both viable and the wisest financial decision.

Suboptimal economic decisions are irrational

White believes that shame and an exaggerated anxiety about the effects of a foreclosure may be keeping homeowners from walking away in droves. Even in non-recourse states such as California and Arizona where foreclosure is the lenders only remedy and personal deficiency judgments cannot be obtained against borrowers, the vast majority of underwater homeowners continue to make their mortgage payments even when they are hundreds of thousands of dollars underwater and have no reasonable prospect of recouping their losses.

While such behavior may appear irrational on its face, behavioral economists liken the behavior of underwater homeowners to the irrationality that leads people to make other suboptimal economic decisions. Underwater homeowners arent knowingly making bad choices, they just cant cognitively grasp that they would be better off if they walked away from their mortgages, White explains.

The moral playing field requires leveling

Walking away from over-encumbered homes may well undermine the basic tenants of mortgage lending, but no more than does taxpayer assistance for lenders who remain unwilling to make interest-rate or other concessions. Rewriting interest rates on existing mortgages would keep many of distressed borrowers in their homes, but lenders have little incentive to make any concessions. Over the last few years, banks can’t be shamed into action.Congress briefly toyed with the idea of a bill that would allow bankruptcy judges to rewrite mortgages, but it was shot down quickly, perhaps thanks to lobbyists.

Walking away may be the most financially responsible choice

Struggle as they may against the emotional constraints pinpointed by White, plenty of homeowners arrive at turning points where they have no choice but to walk away. With 10.7 million people in the US underwater with their mortgages, perhaps a re-evaluation of lending philosophy is in order.Walking away might be the best choice financially for a distressed homeowner, if doing so makes it easier to meet other unsecured obligations and provide a stable income for their dependents.

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