By Alan White
Opponents of mortgage debt reduction, with or without taxpayer subsidies, often invoke moral hazard and strategic default. They argue that if delinquent borrowers are
offered the chance to have part of their debt canceled to prevent foreclosure,
other borrowers who can manage their payments will elect to stop paying in
order to join the debt cancelation program, i.e. they will engage in strategic
default. The problem with this
argument is that it ignores the competing incentives homeowners have to default
in two opposing scenarios--one where mortgages are reduced to home values, and
one where mortgages are not reduced so that homeowners face persistent negative
equity. I am not aware of any good
research quantifying the likelihood that homeowners who can otherwise pay will
default in order to benefit from modification programs. The modifications offered to date, in
both HOPE NOW and HAMP flavors, featuring capitalization of unpaid interest and
temporary rate reductions that lead to future payment shocks, would not tempt a
rational and strategic borrower, but perhaps some future hypothetical
modification program might do so.
Deliberate default to benefit from modifications is a risky strategy
when there is a screening process to determine hardship and eligibility for
modifications is uncertain.
What is well established is that NOT reducing principal will
result in strategic defaults. In
other words, as more homeowners face mortgage debts exceeding their home value,
and the realization sinks in that home values will not return to 2007 levels
any time soon, some will choose to stop paying their debt and walk away. These strategic defaulters would be
much less likely to walk away, and more likely to keep their payment promises,
if their equity was restored through modest debt reduction. A recent study helps to quantify
exactly how much negative equity needs to be eliminated to prevent widespread
strategic defaults.
The study by Luigi Guiso, Paola Sapienza and Luigi Zingales is based on a survey of homeowners. Respondents would not elect to default as soon as their home
equity is negative, due to both economic considerations (relocation costs) and
moral restraints. However, when
the negative equity reaches a certain point they are much more willing to
consider walking away.
Specifically, when negative equity reaches 20%, 12% will walk away, and
at a 50% negative equity level, 17% will walk away. The survey also found that respondents who knew of
mortgage defaults by others judged 26% of them to be strategic. This latter finding, reflecting a variety
of values and judgments about others, should be taken with some skepticism, but is important
because the survey also finds that there is a contagion effect. Other things being equal, homeowners
are more likely to walk away when they perceive that many of their neighbors
have already done so, and more generally when foreclosures in their area
increase.
Strategic default is not linear. There is a tipping point effect, both because moral
restraints on defaulting loosen as negative equity reaches hopeless levels, and
because news of neighbors being foreclosed increases the willingness to walk
away. This all suggests that
principal reduction, targeted at areas with significant and persistent negative
equity, and with the use of appropriate screening to mitigate moral hazard,
will prevent strategic defaults and resulting foreclosure losses.