Carefully crafted strategies behind some mortgage defaults

WASHINGTON — Would you, under any circumstances, default on your home mortgage, even if you could afford to make the monthly payments?

That's a trickier question than you might assume, according to new research from the University of Chicago's Booth School of Business and Northwestern University's Kellogg School of Management.

The study found 26 percent of the record numbers of home-mortgage defaults across the country are "strategic" — that is, calculated economic decisions to bail out of loans by owners who have the money to make the payments but can't handle the negative equity they're carrying caused by local property-value declines.

Nationwide, according to data from Seattle-based Zillow.com, 22 percent of all homeowners in the first quarter of 2009 were "underwater," in negative equity positions with mortgage debts that exceed their home values.

In some parts of California and Nevada, more than half of all households have negative equity. In a few localities, the size of the equity deficit is staggering.

In the Salinas, Calif., metropolitan area, for example, the median equity for people who bought their homes in 2006 near the peak of the boom is now a negative $214,305, according to the study.

When researchers questioned two nationally representative statistical samples of households about strategic defaults, they found that moral and social beliefs play a constraining role, but negative equity and the frequency of defaults in local ZIP codes have significant contrary impacts.

Co-authors Paola Sapienza, Luigi Zingales and Luigi Guiso used interviews with 2,000 households last December and this March to explore the "moral and social" dynamics of strategic defaults.

The two 1,000-person samples came from the Chicago Booth/Kellogg School Financial Trust Index, which monitors the level of trust households have in the financial system.

Their research not only represents the first attitudinal study of the phenomenon of widespread strategic walkaways from home-loan commitments, but also has implications for federal policies seeking to limit the numbers of foreclosures — which are on pace for a record 3.1 million filings this year, according to RealtyTrac.

Among the study's sobering findings:

Moral precepts keep large numbers of financially struggling homeowners out of default, but only to a point. Fully 81 percent of household heads said they believe intentional defaults on mortgages to be "morally wrong."

But that high percentage begins to crumble as negative equity grows increasingly larger.

When negative equity rose to $50,000, 7 percent of those who consider strategic defaults to be immoral said they'd walk away. At $100,000 negative equity, 22 percent would do so.

At negative $200,000, 37 percent of those with moral objections would nonetheless default, and at $300,000, 38 percent said they would.

Among those who had no moral reservations, the percentages were much higher. At $50,000 negative equity, 20 percent said they'd walk. At negative $100,000, 41 percent would do so, as would 59 percent at negative $200,000 and 63 percent at $300,000.

The researchers found that age, tenure of homeownership, the frequency of foreclosures in a person's ZIP code and even politics influence willingness to bail out of a mortgage.

Younger owners under the age of 35 are less likely to have moral problems with strategic defaults, as are self-described political "independents," compared with Republicans and Democrats.

An important factor, according to the researchers, is the level of foreclosures that owners see in their local community and their personal acquaintance with owners who have defaulted.

In the latter case, homeowners who know someone who defaulted strategically are 82 percent more likely to default themselves, compared with owners who do not know anyone in that situation.

The higher the number of foreclosures in a given ZIP code, the higher is willingness to walk away, the researchers found, suggesting a "contagion effect that reduces the social stigma associated with default as defaults become more common."

High numbers of foreclosures also appear to create a "vicious circle" that increases neighbors' own negative equity and greatly raises the probability of additional defaults, foreclosures and equity destruction in the area.

Though the authors offer no specific remedies — they are behavioral researchers, not policy advisers — they argue that the traditional assumption that borrowers default because they can't afford their payments needs to be re-examined in light of accelerating foreclosures in some markets combined with plummeting equity.

The Obama administration appeared to take a step in that direction July 1 when it allowed refinancings of Fannie Mae- and Freddie Mac-owned mortgages where owners have up to 25 percent negative equity. Previously the limit was 5 percent.

Kenneth R. Harney: kenharney@earthlink.net