NCPA - National Center for Policy Analysis

THE MENACE OF STRATEGIC DEFAULT

May 14, 2010

During the run-up to the bursting of the housing bubble, home buyers were confident that house prices would never stop rising.  Most Americans never bothered to check what would happen if they defaulted.   After all, who would walk away from a house worth more than the mortgage, asks Luigi Zingales, a professor of entrepreneurship and finance at the University of Chicago Booth School of Business. 

Today, the matter is far from theoretical for the 15.2 million American households holding mortgages that exceed the value of their homes.  It will help determine how many of them choose to "default strategically" -- that is, walk away from their mortgages even when they can afford them, because they've determined that it's no longer worth it to keep paying.   And that, in turn, will help determine the future health of the American housing market -- and thus of the U.S. economy, says Zingales. 

  • Though the rate of strategic default is hard to determine, one thing seems certain -- the more you owe, relative to the value of your house, the likelier you are to default strategically (nobody will do that if his mortgage is just 10 percent larger than his house is worth).
  • Of households that owe 50 percent more than their houses are worth, the same survey suggests, 25 percent will default strategically.
  • And a New York Fed study estimates that of households that owe 62 percent more than their houses are worth, a full half will default strategically.  

If the underwater homeowners who currently refuse to default changed their minds and decided to abandon their mortgage commitments, the results could be catastrophic.  The more people walk away, the more houses get auctioned off, further depressing real estate prices.  This additional decline would push more homeowners into negative territory, leading to still more defaults.  Adding to the deadliness of this cycle would be the fact that as more strategic defaults occurred, the social stigma associated with them would lessen, says Zingales. 

Source: Luigi Zingales, "The Menace of Strategic Default," City Journal, Spring 2010. 

For text:

http://www.city-journal.org/2010/20_2_strategic-mortgage-default.html 

 

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