Moral and Social Restraints to Strategic Default on Mortgages

6-29-09

Moral and Social Restraints to Strategic Default on Mortgages, a new research paper from Paola Sapienza (Kellogg School of Management at Northwestern University), Luigi Zingales (University of Chicago Booth School of Business) and Luigi Guiso (European University Institute), considers U.S. homeowners' willingness to default on a home loan. 

This study found that when the value of a mortgage exceeds the value of their house, even if the homeowner can afford to pay their mortgage, homeowners begin to show a willingness to default on their mortgage, especially when home values have fallen by 15% or more. 

The study concluded that more than 25% of recent mortgage defaults could be considered "strategic," rather than an inability to make monthly payments.

Using data collected from surveys conducted within the last six months as part of the Financial Trust Index, this paper is the first to examine the economic and moral implications of strategic default in the current recession.  The finding of a strategic motivation to default contrasts with an earlier study of the Boston housing market during the 1990-91 recession in which homes devalued by approximately 10%.  In that study, which Sapienza, Zingales and Guiso believe is the basis for the Obama's administration's current housing policy, found that very few homeowners who could afford their mortgage chose to walk away from their homes.

"Housing policy under the current administration has focused on reducing households' cash flow problems in response to the housing crisis, but no one has addressed the negative equity issue as part of public policy regarding housing," said Sapienza.  "We're in a completely different economic environment today, where for the first time since the Great Depression millions of Americans have mortgage loans that exceed the value of their home."

According to the researchers, moral and social variables play a significant role in predicting strategic default.  People surveyed who said it was immoral to default were 77% less likely to declare their intention to do so, while people who know someone who defaulted were 82 percent more likely to say they would default themselves.

"The most important barriers to strategic default seem to be both moral and social," said Zingales.  "Our research showed there is a 'multiplication effect,' where the social pressure not to default is weakened when homeowners live in areas of high frequency of foreclosures or know others who defaulted strategically.  In fact, the predisposition to default increases with the number of foreclosures in the same ZIP code."

"Factors such as age, location, political affiliation and attitudes toward government intervention also impacted respondents' responses to the morality of strategic default," he added.According to the researchers, moral and social variables play a significant role in predicting strategic default. People surveyed who said it was immoral to default were 77%less likely to declare their intention to do so, while people who know someone who defaulted were 82% more likely to say they would default themselves.

Specifically, the researchers highlighted the following data:

• People under the age of 35 and over the age of 65 were less likely to say it was morally wrong to default compared to middle-aged respondents.

• People with a higher education (8 %) and African-Americans (14%) are less likely to think it is morally wrong to default.

• Respondents with a higher income are more likely to think it is morally wrong.

• Default is considered less morally wrong in the U.S. Northeast (6%) and West (8.5%).

• There was little difference in the moral view of strategic default among Republicans and Democrats, but Independents were less likely to say defaulting is immoral.

• Respondents who supported government intervention to help homeowners were 12% less likely to say strategic default is immoral.

"As defaults become more common, the social stigma attached with defaulting will likely be reduced, especially if there continues to be few repercussions for people who walk away from their loans," concluded Sapienza.  "This has an adverse effect on homeowners who do pay their mortgages, and the after-effects of more defaults and more price collapse could be economic catastrophe."

ABOUT THE SURVEY: On a quarterly basis, the Financial Trust Index captures the amount of trust Americans have in the private institutions in which they can invest their money. The survey is conducted by Social Science Research Solutions (SSRS) using ICR's weekly telephone omnibus service. To assess the frequency and determinants of strategic default, the researchers included variables in surveys conducted with more than 1,000 individuals over two two-week periods in December 2008 and March 2009.

Source:  Kellogg School of Management; PR Newswire