One out of four homeowners defaulting on their mortgage today is doing so, even though they can afford to make their monthly payments.

According to Professor Luigi Zingales of the Chicago Booth School of Business, these individuals are voluntarily choosing to give up their homes because: 1) their house is currently worth less than the balance on their loan, and 2) defaulting on a mortgage is more acceptable these days.  

The term for this is “strategic default.”

Zingales, along with colleagues Paola Sapienza, who teaches at the Kellogg School of Management, and Luigi Guiso, professor at the European Institute, found that people rarely default if the negative equity in their home is 10% or less.  But once that reaches 15%, the tendency to walk away from one’s home increases significantly. Nearly one in five individuals would strategically default if their house were worth 50% less than their mortgage balance.

According to Zingales, the problem with current government programs aimed at helping people avoid foreclosure and keep their homes is that they don’t take this into account.  Instead, legislation has focused on making mortgages more “affordable” by requiring or requesting that lenders to renegotiate the interest rates they’re charging.   While this reduces the size of the monthly mortgage payment a homeowner has to make, it does not reduce the balance on the mortgage itself. 

In their research paper “Moral and Social Constraints to Strategic Default on Mortgages,” the professors point out that “no attempt has been made to resolve the negative equity problem, i.e. the fact that 22% of U.S. households have a mortgage that is bigger than the value of their house.” 

Doing so would mean requiring lenders to reduce the size of the loan, “and that’s what’s controversial,” says Zingales. “Some people say it’s bad to help people don’t want to pay” even though they can afford to. 

Given the fact that such a large number of homeowners are stuck with negative home equity, it’s perhaps surprising that more don’t opt for a strategic default.  Historically, the main constraints have been both moral and social.  But today, both factors have less influence than in the past.  The humiliation of defaulting on a mortgage is a diminishing consideration. 

Those with higher education levels “are less likely to consider it immoral to walk away because they understand that [their mortgage] is a contract with an option to walk away.”  As Zingales points out, under the terms of the document “you have the right to do it.”

Surprisingly, despite the fact that “thrifty” and “financially responsible” are characteristics often attributed to those over age 65, seniors also rank among the demographic groups who are more likely to think it’s not a big deal to walk away from a mortgage.  Compared to Baby Boomers, both retirees and those under age 35 were less likely to say it was morally wrong to default. (1)

The social stigma of turning over your house keys to your lender is also less of a factor due to what Zingales called “the multiplication effect”: the more common defaults are in your neighborhood, the more acceptable it is.  Zingales et al found that the likelihood of default “increases with the number of foreclosures in the same ZIP code.”  In other words, instead of peer pressure preventing someone from defaulting, once a tipping point is reached, there is a kind of peer approval to do so.

In my view, something else has also changed: gone are the days when you walked into your local bank, sat down with your local banker -- who may be your daughter’s softball coach -- and applied for a mortgage.  These days, the whole process has been de-personalized.  

You can apply online or by phone.  You may deal with a broker who works at a mortgage company- not where you bank.  Your loan application is shopped among various lenders that might or might not be financial institutions and which might or might not have a presence in your area. Once your mortgage is approved, it is sold to another firm that packages it with thousands of others that are then sold to investors.

It’s a lot easier to walk away from a mortgage when your local bank doesn’t hold your loan and you don’t have to face your neighbor, the banker, every time you walk in the door. 

Zingales and his co-authors are worried because government policy fails to recognize the impact that strategic defaults are having on real estate prices, especially in certain areas of the country, such as California and Nevada.  They’re concerned we could be headed for a “contagion” where more people walk away from their mortgages, which leaves more vacant homes in an area, which sends real estate values even lower, which puts more mortgages “under water,” which causes more people to default, and so on.

As neighborhoods are literally deserted, he predicts “areas could become deserts.”

The professors’ fear is an ever-widening, downward spiral in residential real estate prices which would continue to drag down the financial sector and prevent an economic recovery. It’s critical, they say, that government policy address the issue of negative equity. 

“Congress needs to approve a law that requires a lender to offer to re-adjust the value of the mortgage [based on the lower] value of the house.”  In exchange for a reduced loan amount, Zingales  proposes that the homeowner would agree to split any future appreciation of the house 50-50 with the lender.

“I’ve sent my proposal to a bunch of Congress[members], but no one has paid attention,” says Zingales.  

However, he admits that it would be tough to put into practice on a large scale.  

“If a bank owns the mortgage, no problem.  But if the mortgage has been put into a pool and securitized, the bank would have to buy back all of the securities in the pool” in order to re-negotiate a single loan.

1) According to their research, the authors found that default is also considered less morally wrong by people who live in the Northeast and Western United States, and African Americans.  There was no meaningful distinction between Republicans and Democrats, however, those registered as “Independents” were more likely to say that it’s immoral to default.  Higher-income Americans tend to agree.

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.