On Mortgages and Moral Compunction

by Sean Purcell

Real Estate Renaissance Man

Author website

What would it take for you to walk away from your mortgage?

Kenneth Harney, in his column Nation’s Housing, reports on an interesting study recently done by the University of Chicago’s Booth School of Business and Northwestern University’s Kellogg School of Management.  This study took a look at homeowner’s attitudes toward mortgage defaults, specifically what’s come to be called “strategic” walkaways or decisions to bail on a mortgage due to purely economic reasons.  The study found that “26% of the record number of home mortgage defaults across the country” were strategic – the homeowner had the ability to pay the mortgage but chose not to because the debt was greater than the asset.  In other words, one in four of the current foreclosures is not due to hardship, but rather a lack of compunction.

My partner and mortgage rate expert, Brian Brady, has for some time now railed against the disappearance of moral compunction with regard to mortgages.  His contention, as I understand it, is that moral compunction was  priced into the model by lenders.  There has historically been a stigma attached to not paying one’s debts, especially one’s home mortgage debt.  This may or may not be true; I am no expert on the history of mortgage defaults in our nation, but it is certainly compelling.  If accurate, the obvious question then becomes: to what degree did moral compunction affect rates and if it is indeed gone, how much higher will rates go?

There is no real mystery to how mortgage rates are priced.  Mathematicians create models of mortgage “behavior” based on the 4 C’s: Capacity, Capital, Collateral and Credit.  Of these four, Credit is really what we’re talking about here.  Your income, your assets and the property’s value are theoretically objective but your credit… well, it’s not really credit that’s being measured here is it?  It’s your Character; your likelihood to honor your debts, although lenders don’t like to say that because it has a snooty, superiority quality.  Make no mistake though, character is most definitely being evaluated during the loan process.   So the question seems to be: How do these mathematicians change the models to reflect a decrease (or abandonment) of moral compunction?

That sounds like a difficult question to answer but I think we can make it a little easier.  If we read further into the study by co-authors Paola Sapienza, Luigi Zingales and Luigi Guiso we realize there is in fact a sliding scale of moral compunction practiced by American homeowners.  (That last statement should be read with tongue in cheek; sliding scale and moral compunction are oxymoronic… you cannot be a little bit pregnant.)  When asked, “81% of household heads said they believe intentional defaults on mortgages to be ‘morally wrong’.”  Yet that number dwindles down as negative equity grows; by the time we get to negative equity of $200,000 fully one in three of these same homeowners would strategically default.  Turns out the act they found “morally wrong” was actually just mis-priced.  In other words, a great many homeowners find morality to be a good thing… taken in moderation.

Besides negative equity, the authors discovered a number of other factors that might influence a homeowner’s decision to strategically default, including age (younger were less likely to have a moral issue) and political affiliation (self-described political independents were also less likely to have a moral issue).  But the other significant factor was familiarity.  Not only did having a greater number of foreclosures within the local community increase the likelihood of a strategic foreclosure, but “owners who (knew) someone who defaulted strategically (were) 82% more likely to default themselves, compared with owners who (did) not know anyone in that situation.”  As the old saying goes: “Familiarity breeds contempt.”

Earlier I wondered how mathematicians could change mortgage pricing models to reflect the empirical observation that making one’s mortgage payment has lost moral compunction.  Based on this study, there is no moral component and probably never was.  The first step then, is to remove the variable of morality altogether.  The model should instead add two more C’s: Community and Contact.

• Community would account for the percentage of foreclosures within a borrower’s local area, probably using the same distance radius now used for comps in appraisals.  Deriving a statistically significant factor for the likelihood of foreclosure based on the percentage of foreclosures within a Community should not be too difficult
• Contact would ascertain whether or not the borrower is acquainted with someone who has walked away from their mortgage.  Again, if a borrower is 82% more likely to walk away from their mortgage based on knowing someone else who has done so, that’s a pretty important variable.

Does that last one sound a little intrusive to you?  We ask similar questions of potential jurors in order to seat an impartial jury.  Is accurately pricing mortgages for the housing industry somehow above such questions?  Have you looked at a mortgage application lately?  It is easily the most intrusive document ever created for general public use.  Have a job?  We want to talk to your employer.  Got divorced?  We want to look at the entire decree.  Own your own business?  You better just send me a copy of every schedule of your tax returns for the past two years.  There is a list of over a dozen declarations you must attest to regarding law suits, bad debts, citizenship and so on.  Another question regarding your familiarity with strategic foreclosures would hardly encumber the process.

Like it or not, this issue has to be resolved.  Without a substantive discussion and response to strategic foreclosures, mortgage pricing models will have no choice but to account for foreclosures – both hardship and strategic – with across the board increases in rates.  That is the easiest hedge against increased risk.  But such indiscriminate rate hikes will only serve to diminish the housing industry and punish the vast majority who have acted responsibly.  Does that sound moral to you?