Is it conditioning, morality, or naïveté?

The question of what motivates underwater homeowners to either stay put and continue to make their mortgage payments (if they can) or "walk away" from their home (and their financial obligations) has been receiving an increasing amount of attention in recent weeks.

In looking at this matter, a good place to begin is with the abstract below from the recent study Underwater and Not Walking Away(.pdf) by Brent White at the University of Arizona:

Contrary to reports that homeowners are increasingly “walking away” from their mortgages, most homeowners continue to make their payments even when they are significantly underwater. This article suggests that most homeowners do not strategically default as a result of two emotional forces: 1) the desire to avoid the shame and guilt of foreclosure; and 2) exaggerated anxiety over foreclosure’s perceived consequences. Moreover, these emotional constraints are actively cultivated by the government and other social control agents in order to induce homeowners to ignore market and legal norms under which strategic default might not only be a viable option, but also the wisest financial decision. Unlike lenders, individual homeowners have thus generally not acted to minimize their losses and have born a disproportionate share of the burden from the housing collapse.

Brent probably has more than enough sample data in Arizona from which to draw and his conclusions are no doubt valid in many other parts of the country as well where the magnitude of the current "underwater homeowner" problem is highly correlated to the size of the mid-decade housing bubble.

But, what is most fascinating about this report is the aspect of "emotional constraints" that are "actively cultivated by the government and other social control agents". Apparently, this has played a major role in getting underwater homeowners to act (or, in this case, not act) in ways that work against their own financial interests.

In the report, White noted comments by the former Treasury Secretary on one of the hottest housing market topics of the day - strategic defaults:

The worst criticism has been reserved, however, for those who would walk away from mortgages that they can afford. Typical of such criticism is that of Secretary of the Treasury Henry Paulson, who declared in a televised speech: “And let me emphasize, any homeowner who can afford his mortgage payment but chooses to walk away from an underwater property is simply a speculator – and one who is not honoring his obligations.”

It seems there is a national movement afoot to divert homeowners' attention away from the degree to which they are underwater on their mortgage and focus on monthly payments, that being the thrust of the recent Making Home Affordable government program to slash interest rates while leaving the outstanding debt intact.

To this point, we have lived in a country where the "What's my monthly payment?" culture has thrived, but that seems to be changing and the question that more and more underwater homeowners are now asking is, "If banks can walk away from their obligations, why can't I?"

This is occurring with increasing frequency, Bloomberg reporting just this morning that Morgan Stanley will "relinquish" five San Francisco office buildings after having purchased them more than two years ago near the top of the market. It's probably no coincidence that the phrase "walking away" is noticeably absent from their account when, in fact, that is exactly what the investment bank is doing.

Maybe the rules are different for big banks than for homeowners.

You'd surely think that this is the case after reading part of this story in today's Wall Street Journal, one in a series of excellent reports in the Journal in recent weeks about "strategic defaults" where the morality issue is neatly captured:

A standard mortgage-loan document reads, "I promise to pay" the amount borrowed plus interest, and some people say that promise should remain good even if it is no longer convenient.

George Brenkert, a professor of business ethics at Georgetown University, says borrowers who can pay -- and weren't deceived by the lender about the nature of the loan -- have a moral responsibility to keep paying. It would be disastrous for the economy if Americans concluded they were free to walk away from such commitments, he says.

What banks have done in recent years has not been a disaster?

And Wall Street firms can walk away from their "obligations" but ordinary Americans can't?

That sort of thinking should be about as popular as Wall Street bonuses right about now.

While simple laziness is surely a big reason why most homeowners will continue to pay $3,500 a month (if they can) for a house that is worth $200,000 less than what they owe instead of sending the keys back to the bank and renting a house down the street for about half the monthly payment, there is clearly a very big moral issue here, one that continues to surprise me every time I run across it.

No stranger to the idea of acting in one's own self interest when it comes to real estate (as detailed here, my wife and I did a short sale back in 1995 when the previous California housing bubble went bust), it does continue to amaze me that, in light of some of the most wretched financial market excesses in history, many homeowners continue to think that we live in a world full of Jimmy Stewart-like bankers instead of those populated with the likes of Hank Paulson and Lloyd Blankfein.

It seems that one homeowner's morality is another homeowner's naïveté, that is, unless the latter truly believe that "the meek shall inherit the earth".

We are, by far, the most religious of all western nations, but the idea of somehow being rewarded in the afterlife for continuing to make mortgage payments to Bank of America is beyond my ability to comprehend.

In a place like California, the terms of the deal are quite clear - the bank either gets the monthly mortgage payments until the loan is paid in full or it gets the house back with very few strings attached. And while the word "promise" appearing in the loan documents may prove too much for some borrowers to surmount, it is clearly not a legal impediment.

Without question, many underwater homeowners are acting against their own self interest by continuing to pay their mortgage if other dramatically less expensive housing arrangements can be made.

One could wait for home values to recoup a $200,000 decline, betting on an even bigger housing bubble materializing someday, all the while making good on the monthly mortgage obligations, but that may take much longer than you think and, in the end, it is sure to be much more costly than you could imagine.

Now, there's a big distinction to be drawn here between, say, the just-married couple who bought a house at the top of the market because that's what people do (that's what we did 20 years ago) and your run-of-the-mill wild-eyed housing speculator circa 2005 who managed to amass a large real estate portfolio without ever having earned a high school diploma.

It's not clear if there is any sympathy anywhere for the latter, but too few seem to see any distinction between the two to the detriment of the non-speculator who seems to go on believing that, today, "if you can continue to pay, you shouldn't walk away".

So, where does this all bring us?

A shocking decline in naïveté or, if you prefer, more immoral behavior on the part of the American public regarding their underwater mortgages may be one of the more important developments for the housing market over the next year or two.