Morality Arguments of Short-Sales

January 23, 2010

MUCH has been said about the high rate of home foreclosures, but the most interesting question may be this: Why is the mortgage default rate so low?

David G. Klein

After all, millions of American homeowners are “underwater,” meaning that they owe more on their mortgages than their homes are worth. In Nevada, nearly two-thirds of homeowners are in this category. Yet most of them are dutifully continuing to pay their mortgages, despite substantial financial incentives for walking away from them.

A family that financed the entire purchase of a $600,000 home in 2006 could now find itself still owing most of that mortgage, even though the home is now worth only $300,000. The family could rent a similar home for much less than its monthly mortgage payment, saving thousands of dollars a year and hundreds of thousands over a decade.

Some homeowners may keep paying because they think it’s immoral to default. This view has been reinforced by government officials like former Treasury Secretary Henry M. Paulson Jr., who while in office said that anyone who walked away from a mortgage would be “simply a speculator — and one who is not honoring his obligation.” (The irony of a former investment banker denouncing speculation seems to have been lost on him.)

But does this really come down to a question of morality?

A provocative paper by Brent White, a law professor at the University of Arizona, makes the case that borrowers are actually suffering from a “norm asymmetry.” In other words, they think they are obligated to repay their loans even if it is not in their financial interest to do so, while their lenders are free to do whatever maximizes profits. It’s as if borrowers are playing in a poker game in which they are the only ones who think bluffing is unethical.

That norm might have been appropriate when the lender was the local banker. More commonly these days, however, the loan was initiated by an aggressive mortgage broker who maximized his fees at the expense of the borrower’s costs, while the debt was packaged and sold to investors who bought mortgage-backed securities in the hope of earning high returns, using models that predicted possible default rates.

The morality argument is especially weak in a state like California or Arizona, where mortgages are so-called nonrecourse loans. That means the mortgage is secured by the home itself; in a default, the lender has no claim on a borrower’s other possessions. Nonrecourse mortgages may be viewed as financial transactions in which the borrower has the explicit option of giving the lender the keys to the house and walking away. Under these circumstances, deciding whether to default might be no more controversial than deciding whether to claim insurance after your house burns down.

In fact, borrowers in nonrecourse states pay extra for the right to default without recourse. In a report prepared for the Department of Housing and Urban Development, Susan Woodward, an economist, estimated that home buyers in such states paid an extra $800 in closing costs for each $100,000 they borrowed. These fees are not made explicit to the borrower, but if they were, more people might be willing to default, figuring that they had paid for the right to do so.

http://www.nytimes.com/2010/01/24/business/economy/24view.html