Today’s WSJ front page trumpets, Americans Pare Down Debt, and proceeds to tout the economic benefits of the “de-leveraging,” to wit: the consumer will have more money with which to buy things, resuming its role as driver of the economy. U.S. household debt fell by 1.7% a first, but this occurred largely by default. Is that good? Certainly de-leveraging by prepaying is good, just as increasing savings is good. The bubbled consumer was, and still is, over-leveraged and under-saved! But is a raft of foreclosures and the concomitant drop in real estate values good?
The other side of the story is that 11.3 million homeowner mortgages, 24%, of the total are underwater. Nevada has 70% sucking for air, Arizona 51%, Florida 48%, Michigan 39%, and California 35%. (See CNNMoney report.) This will double to 22 million mortgages, 48% of the total by 2011 according to a Reuters report. This means that a lot of people are still paying the monthly payments on the underwater mortgages. Alternatively, it means that the lenders have not filed notices of default and started foreclosures. Is this situation good?
Under most state’s laws, borrowers can walk away from mortgages with no personal liability; hand the keys to the bank, which has no recourse against the borrower, and then go out and rent for less than the mortgage payments. Why aren’t more of the 11.3 million borrowers taking advantage of this?
Kevin Hassett penned an intriguing article in the March 8th edition of National Review, Mortgage Mortality, that attempts to answer that conundrum. He posits two alternatives:
First, in the long range it is uneconomic to default on that underwater mortgage. The default has immediate adverse consequences: the credit rating gets hammered raising the price of future loans, the loss of future equity and potential profit when housing values recover, and the loss of tax deductions on mortgage interest. These adverse consequences outweigh the benefit of default.
Second, there is a branch of economic literature which suggests that “Americans’ morality is driving their default decisions.” A recent survey by Guiso, Sapienza and Zingales of homeowners about their willingness to default found out that 80% said that it would be “morally wrong” to strategically default on their mortgages! But caution, these results reversed if the respondent already knew someone who had defaulted.
So maybe it’s not “morality” that keeps homeowners paying the underwater loans, but social stigma or the lack thereof. Hassett cites Dan Ariely’s tome, Predictably Irrational, to buttress this “social stigma” concept which goes back to Adam Smith. Ariely relates a controlled test taking experiment at MIT, where two groups take the same math test, with one given more of an opportunity to cheat by self-reporting results; however, in the self-reporting group, half had to also list 10 books they had read, and half had to list as many of the Ten Commandments as they could remember. The results: cheating occurred in the self-reporting group and to a greater extent in the non-Ten Commandment half of that group!
So do we have a growing ticking time bomb of underwater mortgages? Are the inflated values of those mortgages on bank and investor balance sheets going to create another financial crisis? Is our government doing all it can to hide the problem and support artificial values on the backs of people who can’t afford their mortgages? Should we forecast several Japan-like lost decades or hope that the bomb explodes?
I have no answers but it appears prudent to be well aware of the problems.
Tom Motherway