Consumer Law

Moral Hazard, Strategic Default and Debt Reduction

By Alan White

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. 

Full post as published by CL&P Blog on April 20, 2010 (boomark / email).