Study: Strategic Defaults A Big Threat For the Market

Chicago-New research shows the so-called strategic defaults on mortgage loans, when homeowners with negative equity walk out on properties, are driving the crisis and pose catastrophic dangers for the future of the market.

A study estimates that over 25% of all defaults are "strategic" or caused by lack of repercussion fear and loss of hope once the value of the mortgage exceeds the value of the house, "especially when home values have fallen by more than 15%." The risk increases when homes are devalued by 30% to 40%.

Researchers say this inherent risk needs to be addressed to prevent it from deepening the crisis. "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 co-author Paula Sapienza of Northwestern University. "We are 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."

"Moral and Social Restraints to Strategic Default on Mortgages" looked at homeowners' propensity to default even when they can afford to pay the mortgage was based on data collected in the past six months by the Chicago Booth/Kellogg School Financial Trust Index.

Findings are consistent with a similar study of the 1990-91 recession, which also found that homeowners refrain from (strategic) defaulting as long as negative equity in their homes does not exceed 10% of its value. This year's study found 17% of households would default even if they can afford to pay the mortgage "when the equity shortfall reaches 50% of the value of the house."

The study found certain moral and social factors affect strategic defaults. It found that survey participants who see strategic default as immoral were 77% less likely "to declare their intention to do so." While those who stated they knew someone who had defaulted were 82% more likely to say they would default if they were in a similar situation. Moreover, other factors such as age, location, political affiliation and attitude towards government intervention "also affected respondents' responses to the morality of strategic default," said co-author Luigi Zingales of the University of Chicago.

"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 predisposition to default increases with the number of foreclosures in the same ZIP code."

For example, respondents with higher income are more likely to think it is morally wrong to succumb to such decision. People younger than 35 years and those older than 65 years were less likely to say it was morally wrong to default compared to middle-aged respondents. Also those who were better educated, at 8 percentage points, and African-Americans, at 14 percentage points, are less likely to consider it morally wrong. Regionally, responses also differed. These defaults are considered less morally wrong in the Northeast, at 6 percentage points, and in the West, at 8.5 percentage points. As to political affiliation, apparently it did not have much effect on such choices among Republicans and Democrats. Independents, on the other hand, were less likely to see strategic defaulting as immoral.

Finally the survey found that supporters of government intervention were 12 percentage points less likely to consider strategic default immoral.

Ms. Sapienza says that since defaults have become more common, less social stigma is attached to it, "especially if there continues to be few repercussions for people who walk away form their loans."

She is, however, concerned that this change in attitude will have an adverse effect on homeowners who do pay their mortgages, while the after effects of more defaults and more price collapses "could be economic catastrophe."

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