January 21, 2010

Analysis of Strategic Defaults (2 of 5)

Filed under: Civil Disobedience, Land Reform, Reformism Can't Work — Tags: — Russ @ 4:20 am


In part 1 we discussed Brent White’s finding that people were irrationally unlikely to walk away from their underwater mortgages. But is this really what the numbers say? Economists and pundits who want to deny the bubble and justify the bubble prices confabulate notions about the “large financial, emotional, and psychological investments” (as White quotes one commentator) people have made in their homes. (I wonder – are these the same commentors who otherwise insist on “GDP” as the right measure of economic health and scoff at e.g. happiness indices? It’s always heads-I-win-tails-you-lose, ain’t it?)
They also say homeowners may be risk averse and unwilling to bet their credit rating and other legalistic variables vs. the likelihood of big savings from walking away. They may also dread the hassles of moving. Based on these factors, pro-system economists claim, contrary to their normal ideology, that there’s nothing irrational about failing to walk away even if on paper it looks like the rational move.
But these economic assertions ignore what behavioral economists understand, that people make irrational decisions because they’re inclined to misperceive things in certain characteristic ways. These include the status quo bias, the assumption that things will continue as they are and that this is a good thing; an aversion to complex calculations; a tendency to have more fear of immediate costs than expectation for longer-term gain. Then there’s selective perception, such as failing to notice declining home values in one’s own neighborhood. There’s unjustified overconfidence that things will automatically get better, for example  that the housing market will rebound (the status quo bias, where overridden, tends to be overridden on the optimistic side), as well as that their own income will keep growing. Many of these fed into the bubble in the first place. (Also, given how mobile Americans have been in modern times, few must really have any such motivation as, “I really like the neighborhood, so I’ll stay put.)
So, contrary to the claims of bubble defenders, people are in fact prone to be ignorant of the facts. It’s false and tendentious to rationalize irrationality the way these mercenaries do in their Orwellian way.
But far more important than the existence of this cognitive bias is how it is erected upon and reinforced by an emotional foundation. White says, “as a large body of work in the neurosciences has revealed, much of what passes for cognitive bias is actually emotional bias, reached with no cognitive process whatsoever.” (p.16)
The misperceptions are grounded in homeowners’ emotional tendency to not want to understand and believe in the real situation. They want to believe their homes have retained their value and that this value will continue to increase. They focus on evidence and ideas that seem to confirm this and reject what contradicts it. Contrary evidence may cause them to dig in with their beliefs, a classical feature of cognitive dissonance.
“Thus, if one is to understand how homeowners think, one must understand how they feel.” (p. 17) But so far default modeling has sought to correlate default with just about everything but emotion. Thus we have studies on default vis initial loan-to-value, current equity, credit scores, geography, and unemployment, but few correlating it with shame, guilt, or fear. But the findings here are key.
The important study on this was last year’s report by Luigi Guiso, Paola Sapienza, and Luigi Zingales. They found that 81% of homeowners think it’s immoral to default on a mortgage, and that those who feel that way are 77% less likely to claim they would default under a given circumstance. The study found that once negative equity exceeds 10% of the loan’s value, “moral and social considerations” become the most important factor in predicting strategic default. They also found that knowing someone who has strategically defaulted renders one 82% more likely to declare the willingness to default.
These findings indicate that emotion and social conformity are the most important factors here. So it follows that to the extent propaganda and policy serve to intensify these emotions and guide them along a certain path, to that extent they can affect the incidence of default.
Guiso, Sapienza, and Zingales (GSZ) focus on the herd effect and worry about how modification programs for distressed borrowers may encourage more people to default. This is a longstanding complaint among those opposed to mods. But as White points out, by the same logic one could just as easily predict that the example of the Bailouts, and how wall Street continues to rake in stolen taxpayer money while jobs continue to be destroyed, would be the real incitement to default: “If they can do it, why can’t I?”
To understand which of these is more likely we must look to the evidence that emotion is the primary motivator of both moral beliefs and decision making. Here the evidence is clear – people are less likely to default if they feel it is immoral to do so, and especially if they believe others will also think them immoral. This effect is strong even where people understand on a rational level how they were victimized by predatory lending. Their moral mechanism still fails to direct its fire in that direction.
But there’s another important factor at work here. The GSZ study found that even among those who claim to have no moral qualms about defaulting, only 41% would walk away at $100,000 negative equity. So the reluctance to walk must run even deeper than moral and social guilt.
This leads us to the other great demotivator – fear. As White describes it:

The voices of those who have actually faced foreclosure suggest another powerful emotion that may be keeping homeowners from defaulting: fear. Indeed, the term commonly used to describe foreclosure by those who face it is “terrifying”. As one commentator on foreclosure has noted, “foreclosure is that terrifying word no homeowner ever wants to hear, let alone experience.” People not only fear losing their homes, but fear having ruined credit for life, not being able to find a decent place to live, to buy a car, to get a credit card, to get insurance, to ever buy a house, or even get a job. Foreclosure is seen as the end of life as one knows it: financial suicide to be avoided at all costs.

This goes way beyond a cognitive misconception about the detriment to one’s credit score. Here we’re talking about FDR’s “fear itself – nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.”
This fear doesn’t just spontaneously generate itself. It is socially manufactured and indoctrinated from the top down, as a mode of social control.
So we have the three basic elements in the decision whether or not to default: shame, guilt, fear. White says we need more study to tease out the statistical effects here. But what’s clear is that these are well understood in principle by all rational observers, and in particular by those who stand to profit. “As such, those who benefit from underwater homeowner decisions not to default have not waited for statistical proof of the efficacy of those emotions to cultivate them.” (p. 23)
Lenders, government, and their lackey media have systematically cultivated shame, guilt, and fear. In part 3 we’ll analyze this.


  1. […] he or she has the money to keep paying.   This would be an advance over previous research, which found that even where underwater by hundreds of thousands of dollars, only a minority of homeowners would […]

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  2. […] they’re capable of making the payments. In my previous series on strategic defaults (part 1, part 2, part 3, part 4, and part 5) I discussed the reasons for this. The system’s actions are […]

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  3. […] Can't Work,Relocalization — Tags: strategic default — Russ @ 3:11 am   In part 2 of our analysis of Brent White’s paper on strategic mortgage defaults we saw how the […]

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