Wednesday, April 7, 2010

Zingales on the Menace of Strategic Default

Luigi Zingales (U. Chicago--Business) has an interesting article in the latest City Journal called The Menace of Strategic Default: Homeowners who walk away from their mortgages undermine our financial system.  The idea of "strategic default" is that it might be economically rational for owners of underwater mortgages--where the debt owed is greater than the market value of the home--to walk away, even if they can in fact afford to keep making payments.  Zingales looks at the numbers and surmises that while still low, the number of such "strategic defaults" is on the uptick.  He posits that the only thing preventing a mass movement of strategic defaults is the lingering American normative disapproval of failing to pay debts:

What does prevent people from strategic default, it seems, is their sense of what’s right. More than 80 percent of Americans think that it’s immoral to default on a mortgage if you can afford to pay it, according to a recent paper by Luigi Guiso, Paola Sapienza, and myself, and these people are 77 percent less likely to declare their intention to default strategically than people who don’t find the act immoral.

Zingales is concerned that a breakdown of this social norm could put the entire system at risk.

How much risk? If the underwater homeowners who currently refuse to default changed their minds and decided to abandon their mortgage commitments, the results could be catastrophic. The more people walk away, the more houses get auctioned off, further depressing real-estate prices. This additional decline would push more homeowners into negative territory, leading to still more defaults.

To prevent the catastrophe resulting from such a normative breakdown, Zingales and Eric Posner offer a proposal:

Eric Posner and I have proposed a simple solution to the problem of underwater mortgages. We envision a reform of the bankruptcy code that, in areas where house prices have dropped precipitously, would require lenders to give homeowners the option of resetting their mortgages to the current value of their houses. In exchange, the lenders would get 50 percent of the houses’ future appreciation.

Interesting analysis; read the whole thing.

Matt Festa

Financial Crisis, Mortgage Crisis, Real Estate Transactions, Scholarship, Sun Belt | Permalink

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