The Case for Abandoning Your Mortgage

New U of A discussion paper hits a social nerve

Underwater on your mortgage? Youre one in four.

Underwater on your mortgage? You're one in four.

As the nation’s 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).  While it’s not the first time the subject has ever been broached, debt survival is a sensitive topic today, and White’s suggestions have hit a nerve.

It’s 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 they’re willing to take personal financial risks.  One of those disconcerting risks, of course, is that a foreclosure remains on an individual’s credit report for seven years, making it difficult to obtain new credit.  Although it’s 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 would take a deeper plunge, and banks would become even more hesitant to make loans to both individuals and businesses.  Still, it’s 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.  As White points out, this is a double standard involving contradictory lending moralities.

White, who is a scholar of both behavioral economics and law, just may know what he’s talking about. Clearly, the norms governing borrower behavior are at odds with those governing the tactics 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.  The first is a desire to avoid the shame and guilt of foreclosure and the second is an exaggerated anxiety about the perceived 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 lender’s 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 aren’t knowingly making bad choices, they just can’t 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 couple of years, we have seen that banks cannot be shamed into action.  Congress briefly considered a bill that would have allowed bankruptcy judges rewrite mortgages, but even that relatively modest proposal languished and died last spring.

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 Americans underwater on their mortgages, it may be time to reconsider the prevailing lending morality.  Walking away just may be the most financially responsible choice a distressed homeowner can make, when doing so makes it possible to meet other, unsecured credit obligations and provide a stable income for his or her dependents.

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