Magazine | March 8, 2010, Issue

Mortgage Morality

On the question whether Americans are economy-destroying knaves

‘Political writers,” David Hume once wrote, “have established it as a maxim, that, in contriving any system of government, and fixing the several checks and controls of the constitution, every man ought to be supposed a knave, and to have no other end, in all his actions, than private interest.”

The U.S. housing market is currently putting that supposition to a historic test. If American mortgage borrowers act in their own narrow interests, as “knaves,” they might yet cause an economic collapse worse than anything we have suffered.

At issue is the question of walking out on your mortgage. In many states, mortgage contracts are “nonrecourse loans,” meaning that there is no legal basis for a bank to pursue a defaulter’s assets beyond foreclosing on his house. So a borrower who owes more than his house is worth can simply hand the house keys back and stop making his monthly payments, transferring his loss to the bank — a so-called strategic default.

That fine print on mortgage contracts is proving worrisome. Suppose you bought a $500,000 house in 2006, putting 5 percent down. According to the Case-Shiller Composite 20 index, house prices have dropped about 30 percent since 2006. Applying that average decline, today your hypothetical house is worth $350,000, almost $100,000 less than the outstanding mortgage debt. If you walk away from your mortgage, you pass your $100,000 loss on to the bank. If the bank can’t go after your other assets, why shouldn’t you do it?

The number of Americans facing precisely such a decision is mind-boggling. In November, the Wall Street Journal reported that an estimated 5.3 million Americans were under water by at least 20 percent. A recent report from the Government Accountability Office looked specifically at the high-risk loans called “subprime” or “Alt-A” mortgages. Of the borrowers who took out these loans between 2000 and 2007, nearly six in ten owe more on their mortgages than their homes are worth. In some regions, nearly every 2000–07 subprime mortgage is under water: 94 percent in Las Vegas, 89 percent in Phoenix, and 86 percent in Miami.

Our banks are still recovering from the worst financial crisis in a generation. A massive wave of strategic defaults could stick them with trillions in new losses and precipitate a new financial crisis, one so severe that it could stress the very fabric of society. Indeed, predictions of such a wave have played a central role in the analyses of our best-known professional doomsayers.

The puzzling fact is that Americans have not walked away from their debts in large numbers — at least so far. Only about 10 percent of those with negative equity have defaulted. Why have so few done the “economically rational” thing? And is the wave still coming, or is there something about Americans that makes them unwilling to default, even when it is in their immediate interest to do so?

Given the tremendous stakes, it’s no surprise that economists have spent a great deal of time studying this issue. Two distinct branches of economics literature attempting to explain the reluctance of Americans to default have emerged. Under one line of inquiry, researchers have assumed that Americans are indeed knaves, and that the only reason homeowners have not been walking away from their mortgages in large numbers is that the real costs of default make doing so unattractive. The second branch has used surveys to examine the question of whether we are, in fact, self-interested knaves.

#page#Let’s look more closely at the cold calculations.

If you walk away from your mortgage, you have an immediate financial gain: the amount by which your loan is under water. But there are countervailing costs. Your credit rating gets hammered, raising the price of future loans. You also lose the potential profit on your housing investment should real-estate values increase. And, finally, you will have to start paying rent instead of building equity.

How do the numbers work out? Say the Joneses purchased a home in April 2008 worth $300,000 with nothing down. In November 2009, the home is worth $250,000, and they are considering the financial consequences of walking away. A foreclosure would likely hit the Joneses’ FICO credit score pretty hard. For instance, if they want to buy a new car, they are going to pay more in interest than would typical borrowers in good standing — about $4,464 more over the course of a 36-month loan, according to That $4,464 is a small price relative to the $50,000 benefit they would realize by handing over the house keys.

But there are other costs as well. Most important, mortgage interest is tax-deductible, while rent is not. The monthly mortgage payment, including taxes, for the Joneses’ house would typically run about $2,500 per month. If the Joneses are in the top tax bracket, then deducting their mortgage interest means that the real after-tax cost of that payment is only about $1,700 a month. If the alternative is a rent payment of $2,500 a month, then the after-tax cost of renting is almost $10,000 a year higher than that of owning — and defaulting suddenly looks less attractive.

This point was driven home powerfully in a recent study by Federal Reserve economists Christopher Foote, Kristopher Gerardi, and Paul Willen, who took a more comprehensive look at the costs and benefits of defaulting and concluded that “it is optimal for most negative-equity borrowers to stay in their homes.” So it is possible that Americans are keeping up with their mortgages only because it makes no economic sense to default. If that is true, then a wave of defaults still might hit us if real-estate prices drop a little bit more.

The second branch of the economics literature suggests that Americans’ morality is driving their default decisions. If that is true, then future default behavior will be much harder to predict, even we assume if prices decline further.

Economists Luigi Guiso, Paola Sapienza, and Luigi Zingales set out to better understand the drivers of strategic default, using a novel approach for economists: They surveyed homeowners about their willingness to default on their mortgages under a number of hypothetical circumstances.

The results were startling. Fully 80 percent of individuals said they thought it would be “morally wrong” to strategically default on their mortgages. The economists correlated these responses with default behavior and found that moral beliefs indeed influence decisions: Individuals were 77 percent less likely to declare their intention to default if they said it would be morally wrong to do so.

But the survey also raised a red flag: People were 82 percent more likely to state an intention to default if they knew someone who had already defaulted. It seems, then, that Americans think it’s wrong to default, but this conviction is dependent, in part, on their friends’ circumstances.

An explanation of that fact may lurk in Dan Ariely’s recent masterpiece, Predictably Irrational. Ariely focuses a bright light on the relationship between our moral convictions and our economic actions. He begins his discussion with reference to Adam Smith, who anticipated the moral revulsion toward strategic default more than 200 years ago when he wrote that “the success of most people . . . almost always depends upon the favour and good opinion of their neighbours and equals; and without a tolerably regular conduct these can very seldom be obtained.” In other words, stigma matters. But Ariely’s work also reveals that individuals’ moral views are malleable, and that they might change their conduct radically with small modifications in the way issues are framed.

#page#Ariely’s most thought-provoking experiment tested the willingness of students to cheat. A simple math test was devised, and students were given a fixed amount of time to complete it, with a reward for each correct answer. The subjects, all students at MIT, were divided into two groups: a control group that handed in their tests to be graded, and therefore had no chance to cheat, and a second group that reported their own scores and could fudge the results.

And there was an interesting twist: Of the students who had the chance to cheat, half were asked beforehand to list ten books that they remembered reading in high school, while the rest were asked to write down as many of the Ten Commandments as they could remember.

The results were stunning. On average, students in the control group answered 3.1 problems correctly. Students in the second group took the opportunity to cheat — under certain conditions: The ones who started by listing ten books from high school cheated, on average reporting that they had answered 4.1 problems correctly. The students who were asked to recall the Ten Commandments, by contrast, did not cheat, reporting on average 3.0 correct answers.

Apparently, thinking about the Ten Commandments put students in a moral frame of mind.

When faced with the question of strategic default, Americans seem to be acting like these students. They feel, as Adam Smith suggested, a strong compulsion to be viewed as honorable by their fellow citizens. But like Hume’s opportunistic knave, they can turn their morality on and off. If borrowers see their friends walk out on their mortgages with little or no consequence, they may conclude that the gains to be had from defaulting are worth the cost.

There are other possible explanations. For instance, some borrowers may be operating under a different moral calculus, reasoning that banks entered into these subprime-mortgage contracts willingly and charged higher interest rates to compensate for the risk of default. Under this analysis, those higher interest payments bought borrowers the option of strategic default. Where is the crime in exercising that option if it is in your interest? After all, you paid for it.

If that argument holds sway — if knavery carries the day and the economic variables change enough to make default desirable — then all hell may yet break loose.

Perhaps our best hope is to be found in the observation that most Americans still find something morally repugnant in strategic defaults, and in the evidence that our collective willingness to set aside our moral convictions may be held in check if enough people remember the Ten Commandments at the right moment and think: Thou shalt make thy mortgage payment.

– Mr. Hassett is director of economic-policy studies at the American Enterprise Institute.

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