Thursday, November 5, 2009

Professor: Underwater homeowners acting irrationally

I bet this professor didn't get a government grant for this study (emphasis mine):

Millions of American homeowners are "underwater" on their mortgages – owing more than the value of their homes – and would be better off walking away.
...
"These emotional constraints are deliberately cultivated by the government and lenders who self-servingly tell borrowers that they have a moral and social obligation to pay their underwater mortgages," said White of the UA's James E. Rogers College of Law.

"Meanwhile, lenders ruthlessly seek to maximize profits or minimize losses irrespective of concerns of morality or social responsibility," he added.
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He argues that while irresponsible lenders have received government bailouts, responsible homeowners "who just happened to buy at the wrong time continue to bear a disproportionate burden of the housing collapse."
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"The government, lenders, and credit-counseling agencies bombard homeowners with moral and fear-laden messages that overstate the consequences of foreclosure," said White.

"Moreover, as a way of enforcing the double moral standard, lenders hold borrowers' credit scores as collateral and will trash it in retaliation for the borrower's exercise of their contractual option to default."

"Lenders don't want these houses and, with the government's help, do what they can to scare and shame borrowers into making what is in many cases a bad financial decision to stay in their home."
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"To the contrary, walking away may be the most financially responsible choice if it allows one to meet one's unsecured credit obligations or provide for the future economic stability of one's family," he said.
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"The current housing bust should be viewed for what it is: a failure to regulate – not a moral failure on the part of American homeowners," White said.

I haven't read the paper yet but I will put it on the reading list for tomorrow night. I don't think one professor will get much airplay but most of the stuff I have heard him say so far I have agreed with. Though I disagree that the credit score hit is asymmetrically unfair as the borrower is causing a loss to the lender in that situation when taking the aforementioned option to walk away. The smartest financial decision for many is to walk away and hit the reset button. But emotion and logic don't mix. People don't want to admit failure and will go to great lengths not to do so. Many people will continue to throw good money after bad and the banks are counting on that.

4 comments:

Sean said...

Go strategic defaulters! Lending, particularly secured lending, is amoral. Do the math and if it is more efficent to breach the contract than to perform, breach.

Richie said...

Every new car depreciates as soon as you drive it off the car lot. Therefore, many (depending on downpayment) car buyers are underwater on their cars for the first 2 or 3 years of the loan.

Does this mean that these borrowers should quit paying on these loans and let their car get repossessed?

Effective Demand said...

"Every new car depreciates as soon as you drive it off the car lot. Therefore, many (depending on downpayment) car buyers are underwater on their cars for the first 2 or 3 years of the loan.

Does this mean that these borrowers should quit paying on these loans and let their car get repossessed?"

Umm no. There are several factors going on..

First people know that the value of the car will depreciate the instant they drive it off the lot. They are willing to pay that "new car" premium. That new car premium is mostly an emotional premium.

Second, the mistake is relatively small. The longer you keep your car the smaller the mistake becomes. I keep my cars 10 years at least so I buy a cheap new car and drive it into the ground. The premium for buying new for me might be one or two hundred dollars a year and I am ok with it. Not something that my future financial health would be in jeopardy for doing it. Now if I bought every few years and kept trading in.. then the accumulation of waste starts to become high and I better have money to burn to compensate for it.

If you ever want to see the first point in action just watch ebay. You can buy many items absolutely brand new for 10-20 cents on the dollar. Some of the discount is uncertaintity of the seller or getting the right product, other is the time value of shopping and waiting for the item, but much of that discount is simply the emotional difference that stores spend so much advertising dollars building.

People make financial mistakes every day, significantly overpaying for a home is large enough of one where people should reflect on whether they should keep throwing good money after bad or if there are some better solutions for their personal situation. I don't think people are even giving it much rational thought since the problem is complex, overwhelming and there are significant societal biases against doing so.

Richie said...

But when you buy a car, there is a zero percent chance that you would be able to sell that car for the price you paid for it - at some point during the term of the loan.

When you buy a house, even at peak prices, chances are good that you will be able to sell that house for the same price (or more) than you paid for it - at some point during the 30-year mortgage.

There was a day when you looked at that house and decided you can afford it and it was a fair price. You signed contracts in relation to that. So as long as you can continue to afford to pay for it, I don't see why you should ever quit paying.