Maybe LTVs Don’t Matter As Much as You Think

April 30, 2010

by Scott Sambucci


At this week’s “Real Estate Investors Summit” hosted by Opal Financial Group, I was asked about the likelihood of mass strategic defaults for underwater homeowners (“negative equity” in mortgage-speak).   The timing of the question was particularly interesting, as I’m halfway through Dan Ariely’s “Predictably Irrational” – a good read on the irrationalities of everyday life that includes a look at the impact of social norms on economic decisions. It seems there’s an emerging gap between what homeowners ought to do from an empirical standpoint and what they’re actually doing.  But, in the end, is there another factor besides LTVs and social norms not yet considered by most analysts for underwater mortgages?

Fish image - it's not that good up hereIn his December paper – “Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis” – Brent White from the University of Arizona wrote about the economic cost-benefit vs. social effects placed on negative equity homeowners.  White’s paper made the rounds on the blog circuit – Paul Kedrosky noted his intrigue. Felix Salmon published “The world’s largest guilt trip.” James Hagerty at the opined as well.

White explains the empirics of the strategic walkaway to show that underwater homeowners should simply walkaway when faced with a negative equity situation:

And it’s not because the financial costs of foreclosure outweigh the benefits. To be sure, foreclosure comes with costs, including a significant negative impact on one’s credit rating. But assuming one had otherwise good credit, and continues to meet other credit obligations, one can have a good credit rating again – meaning above 660 – within two years after a foreclosure.

Additionally, in as little as three years, one can qualify for a federally-insured FHA loan to purchase another home. While the actual financial cost of having a poor credit score for a few years may be hard to quantify, it is not likely to be significant for most individuals – especially not when compared to the savings from walking away from a seriously underwater mortgage. While a good credit score might save an average person ten of thousands of dollars over the course of a lifetime, a few years of poor credit shouldn’t cost more than few thousand dollars. Moreover, one who plans to strategically default can take steps to minimize even this marginal cost. For example, one could purchase a new vehicle, secure a new home to rent, or even purchase a new house before beginning the process of defaulting on one’s mortgage. Most individuals should be able to plan in advance for a few years of limited credit.

In the 16 metros examined by the US Government Accountability Office report – Loan Performance and Negative Home Equity in the Nonprime Mortgage Market – 59.7% of homeowners were estimated to have negative equity in their home.  While a portion of those negative equity situations may be slight (say under 1-10% negative equity), which one would assume to be tolerable to most homeowners, most negative equity situations are much greater. It follows that based purely on empirical rationale that these metros should then see a 50%+ walkaway rate, yet that’s not the case.   This chasm between expected and actual behavior can drive rational theory economists batty (“C’mon people! Get with it! Foreclosure already!”).   White writes:

While such behavior may appear irrational on its face, behavioral economists explain that underwater homeowners simply suffer from the same kind of cognitive biases that lead individuals to make other suboptimal  economic decisions. Underwater homeowners aren’t knowingly making bad choices; they just can’t cognitively grasp  that they would be better off if they walked away from their mortgages.

White just published a second paper this week – “Beyond Guilt in the Housing Crisis: The Morality of Strategic Default” – that discusses the moral component that homeowners feels when it comes to repaying mortgages. White writes:

Would it be immoral for you to break your contractual “promise” to pay $100 for two years, and elect instead to pay the early termination fee? Of course not. The option to breach your “promise” to pay is part of the contract, as is the consequence of breach – a $300 early termination fee. There is absolutely nothing immoral about exercising your option to breach, and you’d be financially wise to do so.

Though a mortgage contract is more substantial, and involves a home, it is simply a contract, just like a cell phone contract. Like a cell phone contract, a mortgage contract explicitly sets out the consequences of breach.

You’d think we’re witnessing the theme of Ariely’s book play out on a macro scale – that some economic decisions are decidedly irrational.

In the December paper, White discusses a July 2009 NBER Working Paper – “Moral and Social Constraints to Strategic Default on Mortgages” by Luigi Guiso, Paola Sapienza, and Luigi Zingales. As White notes, this NBER paper finds that:

“… 81% of homeowners believe that it is immoral to default on a mortgage, and that homeowners who hold this attitude are 77% less likely to declare their intention to default than those who do not. Indeed, once the equity shortfall exceeds 10% of a home’s value, the study found that “moral and social considerations” are the “most important variables predicting strategic default.” So strong are these variables, in fact, that only 17% of homeowners indicted that they would default if the equity shortfall reached 50%. On the other hand, the study found that people who know someone who has strategically defaulted are 82% more likely to declare their intention to do so. (my emphasis added)”

At some point, peer pressure may start to impact the decision of negative equity homeowners, even those with a guilt complex.  Going back Dan Ariely, he theorizes that we live in two worlds – one characterized by social exchanges and one characterized by market exchanges.  When underwater homeowners perceive that they are socially and morally expected to continue to pay their mortgages, they will.  But, when those social norms are broken or changed by other underwater homeowners walking away, then those constraints dissolve.  Social norms and social expectations matter when it comes to strategic walkaways for underwater mortgage holders – both keeping people on schedule to pay their mortgages, or potentially creating a tidal wave of walkaways.  As soon as more underwater homeowners start walking away, we’ll start seeing more homeowners walk away. But we’re not seeing that happen.  In fact, foreclosure activity is in decline in places like California for example (“California Foreclosure Activity Declines Again“). Why is that?

In several previous posts, I’ve cited a Public Policy Discussion Paper by Christopher Foote, Kristopher Gerardi and Paul Willen at the FRB Boston – “Negative Equity and Foreclosure: Theory and Evidence”- which offers empirical proof that underwater homeowners do not automatically walkaway.  One explanation might be an individual’s perspective on what is “rational.”  A homeowner that considers a moral component in their walkaway decision process enumerates the value of maintaining self-imposed moral behavioral constraints. When added to the empirical rationale for walking away,  a new definition of rational behavior results (“I should pay my mortgage because I promised I would”) that differs from the traditional economic definition includes the empirical component (“I’m underwater therefore I should walk away”). To that homeowner, it is completely rational NOT to walkaway because of the weights of these self-imposed guidelines in their personal utility function.  To this individual, feeling guilty or breaking a promise is worse than living in a financially disadvantaged situation.  But there has to be some middle ground, right?  Some people are walking away after all…

So, is there another variable in action here?  Perhaps market conditions are influencing homeowner pyschology. All of the empirical analysis on walkaway rates hinge on current LTVs as the decision metric.  Maybe LTVs, or even social norms, aren’t the only factor weighed by the homeowner. The real estate market, like any market, is active and changes every day.  Today’s underwater mortgage, even a really really underwater mortgage, is only a couple of appreciation cycles away from getting back to even, or even above water.

Let’s put some numbers to it. Assume you bought a home in Los Angeles in 2006 for $500,000 with an FHA mortgage. With 3% down, the initial loan amount was $485,000. After the housing crash, your home is now valued at $300,000 (a 40% valuation loss). Starting today at $300,000, assume 5% appreciation per year for the next 10 years. A home valued at $300,000 today would be worth approximately $488,000 in April 2021 – close to even. While that sounds crazy to think that this example housing market will appreciate at 5% a year for 10 years, it’s certainly possible that underwater homeowners, in aggregate, are seeing that trend play out this year.

Q1 numbers from California offers an illustration. California home prices stabilized last year and are moving higher this Spring:

California Home Price Trends since April 2008 (source: Altos Research)

California Home Price Trends since April 2008, 90-day rolling average

See how active listings hit a seasonal trough, and new listings entering the market bounced from their lows?  This indicates seller confidence based on aggregate local market activity this Spring. When the underwater homeowner sees this positive activity, the LA homeowner in our example might see a 5% appreciation this year.  The thought process is – “Hey – it’s getting better out there.  I really don’t want to move and I’m starting to see the light if the market keeps heading this way. If I walk away, my credit is shot for three years and if the market trends continue this way, I’ll end up paying a higher price in three years to re-purchase the exact same home.  It doesn’t make sense to walk away.” It could be unfounded optimism for the homeowner to think that the market will appreciate 5% per year for 10 years, but if that’s the psychology, that is going to be the decision.  Want more proof? Check out last week’s post about Homeowner Hank down in Dallas.

I’d argue that market psychology, based on local market conditions, plays a significant role in whether an underwater mortgage holder walks away or not. Homeowner confidence based on real-time local market conditions may in fact weigh more than traditional LTV measures or even social norms.  The decision not to walkaway is perceived as  irrational behavior.  But maybe growing homeowner confidence based on local market conditions is a whole lot more rational than walking away just because of a negative LTV today. Homeowners are in rough waters across the country, but before your get out the life jacket and snorkel, consider that it’s not a binary condition where negative equity equates to a walkaway.  Market conditions matter.

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