Strategic Default Meme

Stuyvestant Town and Peter Cooper Village: another investment underwater.  Photos from the NY Times.

Here's the idea.  The American housing market has become so bad that many indebted homeowners, perhaps up to ten percent of all mortgage holders, are now shouldering a repayment schedule so onerous that they would be better off returning the keys to the bank and finding their family a nicer rental someplace else. If enough people wake up to this reality and act accordingly the feeble property market could enter another round of unrestrained blood letting. 

The theory has been bubbling away in a number of news sources.  I first read about it before Christmas thanks to Daniel Gross at Slate/The Big Money.  He cited the Wall Street Journal's forecasts that in 2009 one million Americans will stop making payments on properties that they could actually afford with a bit more budgeting or additional income.  Then Nudge author Richard M. Thaler opined on these same homeowners in the New York Times, exploring what behavioral norms prevented people from making a rational business decision not to throw good money after bad.  The Planet Money podcast from NPR chimed in on the matter last week, chatting with a property lawyer in Arizona.  When the idea finally landed in the business section of the New York Times yesterday, the meme was certainly off and running fast.

Many American property buyers of the last few years owe much more on their house than the current value of the property, estimates say up to two-thirds of homes in Nevada are worth only 75% of their debtload.  Government help to rectify this situation has been slow in coming, and the programs in place usually require owners to burn through most of their assets to qualify for any assistance.  Faced with these circumstances, the theory goes, homeowners will jettison the big monthly payments to the bank that produce little equity, essentially giving up the house.   Willfully ceasing all payments and submitting to foreclosure is called strategic default, and it sometimes makes economic sense.  This really seems rational in states like California and Arizona where laws prohibit banks from suing borrowers for additional assets to recoup losses.  Lenders can repossess only the house.

But economic decisions involves more than dollars and cents.  Life presents numerous obstacles to any homeowner who wants to simply quit on his/her mortgage.  The most obvious hurdle involves finding another place to live, a significant disruption that potentially involves changing schools or seeking a different job amidst high unemployment.  People also fear damaging their credit-worthy reputations, though Arizona professor Brent White, whose paper (pdf link) prompted all this media hand-wringing, estimates that property holders generally overestimate the ill-effects of foreclosure.  The biggest obstacle might be the shame associated with reneging on a debt, but White calls this a "norm assymetry" because debtors feel obliged or compelled to pay even though no one expects lending companies to adhere to the same morals.

Indeed many of the writers above have cited public indignation about bank bailouts and the me-first mentality of corporate institutions as the spark that might finally prompt homeowners to burn down so much deadwood.  Lenders have steadfastly refused to write down the principal amounts owed for unfeasible mortgages, while other businesses visibly quit on loans they owe to creditors.  Gross mentions the amusement park chain Six Flags declared bankruptcy when faced with an interest payment of $300 million.  The corporation did not have the cash, but software billionaire Bill Gates, an eleven-percent stakeholder, certainly did.  Of course, any businessman would call Gates a fool had he tapped  his personal wealth to prop up a firm that has been declining for years.  Then Tishman Speyer and BlackRock announced in January that they made a bad decision in buying Stuyvesant Town and Peter Cooper Village for $5.4 billion.  Faced with falling rental prices around the city and unable to evict long-term, subsidized renters fast enough to replace them with tenants paying market rates, the company did not dig deeper or declare bankruptcy but opted to "transfer control ...of the property ...to the lenders and their representatives."  Tishman and BlackRock stopped paying and cut their losses.  Public pension funds and other investors got wiped out.  Such understandable but cold business calculations do not encourage Americans  to keep paying off devalued homes by liquidating retirement accounts or raiding college funds.