Housing Crisis by Brent T. White

A thought provoking discussion....

Arizona Legal Studies

Discussion Paper No. 09­35

Underwater and Not Walking Away:

Shame, Fear and the Social Management of the

Housing Crisis

Brent T. White

The University of Arizona

James E. Rogers College of Law

November 2009

Underwater and Not Walking Away:

Shame, Fear and the Social Management of the Housing Crisis

Brent T. White*

Abstract

Despite 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 choose

not to 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

encourage homeowners to follow social and moral norms related

to the honoring of financial obligations - and to ignore market and

legal norms under which strategic default might be both viable and

the wisest financial decision. Norms governing homeowner

behavior stand in sharp contrast to norms governing lenders, who

seek to maximize profits or minimize losses irrespective of

concerns of morality or social responsibility. This norm

asymmetry leads to distributional inequalities in which individual

homeowners shoulder a disproportionate burden from the housing

collapse.

TABLE OF CONTENTS

I. Introduction ......................................................................... 1

II. Underwater and Staying Put ............................................... 3

III. The Financial Logic of Walking Away .............................. 7

IV. Explaining Homeowner Choices ...................................... 13

V. The Social Control of the Housing Crisis ......................... 23

VI. The Asymmetry of Homeowner and Lender Norms ........ 35

VII. Leveling the Playing Field ................................................ 40

*

Associate Professor Law, University of Arizona, James E. Rogers

College of Law.

I. Introduction

Millions of homeowners in the United States are

“underwater” on their mortgages, meaning that they owe more than

their homes are worth.1 Yet, despite all the concern over

homeowners who are simply “walking away” from their homes,2

While such behavior may appear irrational on its face,

the vast majority of underwater homeowners continue to make

their mortgage payments - even when they are hundreds of

thousands of dollars underwater and have no reasonable prospect

of recouping their losses. This includes underwater homeowners

that live in “non-recourse states” such as California and Arizona,

where lenders cannot pursue defaulting homeowners for a

deficiency judgment.

3

behavioral economists explain that underwater homeowners simply

suffer from the same kind of cognitive biases that lead individuals

to make other suboptimal economic decisions.4

The behavioral economic explanation doesn’t account,

however, for homeowners who are fully aware that it would be in

Underwater

homeowners aren’t knowingly making bad choices, they just can’t

cognitively grasp that they would be better off if they walked away

from their mortgages.

1

See, e.g., First American CoreLogic, Negative Equity Report (Aug.

13, 2009)(reporting that 15.2 million U.S. mortgages were underwater in the

second quarter of 2009); See also October Oversight Report: An Assessment of

Foreclosure Mitigation Efforts after Six Months, Congressional Oversight Panel

25 (October 9, 2009)(reporting that between 15-17 million homeowners are, or

soon may be, underwater).

2

See, e.g., David Streitfeld, When Debtors Decide to Default, N.Y.

TIMES, July 25, 2009; Brian Eckhouse, More Homeowners Wrestling With

Ethics of Walking Away, LAS VEGAS SUN, March 23, 2009; John A. Schoen,

Why It’s a Bad Idea to Walk Away From the Mortgage, MSNBC, March 16,

2009; Fox Business: Some Homeowners Who Can’t Pay Choosing to Just Walk

Away (Fox television broadcast company Feb. 19, 2009); Liz Pulliam Weston,

When to Walk Away From a Mortgage, MSN MONEY, June 5, 2008;K Barbara

Kiviat, Walking Away From Your Mortgage, TIME June 19, 2008; 60 Minutes:

The U.S. Mortgage Meltdown (CBS broadcast May 25, 2008) available at

http://www.cbsnews.com/video/watch/?id=4126094n&tag=related;photovideo;

Economy: Why Not Just Walk Away From A Home? (NPR radio broadcast Feb.

13, 2008) available at

http://www.npr.org/templates/story/story.php?storyId=18958049

3

Yongheng Deng & John M. Quigley, Woodhead Behavior and the

Pricing of Residential Mortgages 3-4 (Berkeley Program on Hous. and Urban

Pol., Working Paper No. W00-004, 2004), available at

http://urbanpolicy.berkeley.edu/pdf/DQ_Woodhead_Web.pdf.

4

See Peter Ubel, Human Nature and the Financial Crisis, FORBES,

Feb. 22, 2009, http://www.forbes.com/2009/02/20/behavioral-economics-

mortgage-opinions-contributors_financial_crisis.html.

Underwater and Not Walking Away

2

their financial best interest to default, but still don’t do so. This

article suggest that most underwater homeowners don’t default as a

result of two emotional forces: 1) the desire to avoid the shame or

guilt associated with foreclosure; and 2) fear over the perceived

consequences of foreclosure - consequences that are in actuality

much less severe than most homeowners have been led to believe.

Moreover, fear, shame, and guilt are not mere “transaction

costs” that homeowners calculate according to their own personal

tolerance for each. Rather, these emotional constraints are actively

cultivated by the government, the financial industry, and other

social control agents in order to induce individual homeowners to

act in ways that are against their own self interest, but which are -

wrongly this article contends - argued to be socially beneficial.

Unlike lenders who seek to maximize profits irrespective of

concerns of morality or social responsibility, individual

homeowners are encouraged to behave in accordance with social

and moral norms requiring that individuals keep promises and

honor financial obligations. Thus, individual homeowners tend to

ignore market and legal norms under which strategic default might

not only be a viable option but also the wisest financial decision.

Lenders, on the other hand, have generally resisted calls to modify

underwater mortgages despite the fact that it would be both

socially beneficial and morally responsible for them to do so. This

norm asymmetry has lead to distributional inequalities in which

individual homeowners shoulder a disproportionate burden from

the housing collapse.

This article proceeds as follows: Section II shows that,

despite widespread concern that underwater homeowners are

simply walking away, the vast majority of underwater homeowners

have not strategically defaulted on their mortgages. Section III

explores the financial logic of walking away from an underwater

mortgage and suggests that many more homeowners should be

strategically defaulting. Section IV argues that though cognitive

biases may account for many underwater homeowners’ decisions

not to strategically default, emotions such as shame, guilt, and fear

play the largest role in homeowner decisions to knowingly eschew

“in the money” default options. Section V argues that social

control agents such as the government, the media, and the financial

industry use both moral suasion and disinformation to cultivate

these emotional constraints in homeowners. It also argues that

credit rating agencies play a central role as enforcers of moral and

social norms against walking away from one’s mortgage. Section

VI argues that the disparity between the norms governing the

behavior of individuals and banks has created an imbalance in

which individual homeowners have born a disproportionate

financial burden from the housing collapse. Section VII explores

Underwater and Not Walking Away

3

ways to either address the distributional inequalities of norm

asymmetry or to empower homeowners to renegotiate underwater

mortgages on a more level playing field with lenders.

II. Underwater and Staying Put

As of June 2009, more than 32% of all mortgaged

properties in the U.S. were “underwater,” meaning that the

homeowner owed more on their mortgage than their home was

worth.5 This percentage is expected to increase to 48% by the first

quarter of 2011,6 by which time housing prices in the largest 100

metropolitan areas are predicted to have dropped 42% from their

peak.7 The national numbers hide the full extent of the problem,

however, as the percentage of underwater mortgages is much

higher in the regions suffering the worst price declines. For

example, as of June 30, 2009, 66 percent of mortgage borrowers

were already underwater in Nevada, 51 percent were underwater in

Arizona, 49 percent were underwater in Florida, 48 percent were

underwater in Michigan, and 42 percent were underwater in

California.8 As shown in the chart below, the percentage of

underwater mortgages is higher still if one isolates the hardest hit

metropolitan areas:9

Metropolitan

Statistical Area Current Percent

Underwater

Merced, CA 85

El Centro, CA 85

Modesto, CA 84

Las Vegas, NV 81

Stockton, CA 81

Bakersfield, CA 79

Port St. Lucie, FL 79

Riverside-San Bernardino, CA 78

5

First American CoreLogic, Negative Equity Report (Aug. 13, 2009).

“The aggregate property value for loans in a negative equity position was $3.4

trillion…. In California, the aggregate value of homes that are in negative equity

was $969 billion, followed by Florida ($432 billion), New Jersey ($146 billion),

Illinois ($146 billion) and Arizona ($140 billion). Los Angeles had over $310

billion in aggregate property value in a negative equity position, followed by

New York ($183 billion), Miami ($152 billion), Washington, DC ($149 billion)

and Chicago ($134 billion).” Id.

6

Drowning in Debt – A Look at “Underwater” Homeowners 4,

Deutsche Bank, August 5, 2009. (on file with author)(also noting that “41% of

prime conforming borrowers and 46% of prime jumbo borrowers will be

underwater”)

7

Update: The Outlook For U.S. Home Prices, Deutsche Bank, June 15,

2009 (on file with author)

8

First American CoreLogic, Negative Equity Report (Aug. 13, 2009).

9

Percentages from Drowning in Debt, supra note 6.

Underwater and Not Walking Away

4

Cape Coral-Fort Myers, FL 76

Yuba City, CA 73

Madera, CA 72

Fresno, CA 72

Orlando-Kissimmee, FL 71

Visalia-Porterville, CA 70

Miami-Miami Beach, FL 70

Palm Bay-Titusville, FL 69

Lakeland-Winter Haven, FL 69

Phoenix-Mesa-Scottsdale, AZ 68

As of the second quarter of 2009, over 16% of homeowners

had negative equity exceeding 20% of their home’s value, and over

22% of homeowners had negative equity exceeding 10% of their

home’s value.10 Again, however, the situation is worse in the

hardest hit markets. For example, 47% percent of homeowners in

Nevada had negative equity exceeding 25% of their home’s value,

as did 30% of homeowners in Florida, 29% in Arizona, and 25% in

California. Moreover, given the high median home prices at the

peak within these markets, a large percentage of these homeowners

are underwater by hundreds of thousands of dollars.11

The extent of the negative equity problem is a significant

contributing factor to a combined foreclosure and 30+ day

delinquency rate for home mortgages exceeding 13 percent, a

historic high.

12

10

First American CoreLogic, Negative Equity Report (Aug. 13, 2009).

However, the high foreclosure and delinquency

11

Id. For example, a homeowner who bought a home in 2006 in

Salinas, California, where home prices have dropped 70% from the peak, has on

average $214,000 in negative equity. Luigi Guiso, Paola Sapienza & Luigi

Zingales, Moral and Social Constraints to Strategic Default on Mortgages 2

(Nat’l Bureau of Econ. Research, Working Paper No. 15145, July 2009)

Moreover, given that average home prices reached over $580,000 in Salinas at

the peak, homeowners who bought even slightly better-than-average homes

could easily have negative equity exceeding $300,000. The story is the same,

of course, in other California metro areas, including Los Angeles, Modesto, El

Centro, Merced, Riverside, and Redding. The situation is also dire outside of

California. A homeowner who bought an average home near the peak in Las

Vegas for example – where prices have dropped 52% - would likely have

negative equity in excess of $120,000. The situation is the same in Miami

where prices are down 48%, and in Phoenix, where prices have dropped 54%.

Furthermore, with such significant price decreases in each of these markets, a

large number of individuals who bought more-expensive-than-average homes

have negative equity easily topping $200,000 to $300,000. Standard &

Poor’s/Case-Schiller, Home Price Values for July 2009 (Sep. 29, 2009)(on file

with author)

12

As of the second quarter of 2009, the foreclosure rate was 4.3 percent

and the delinquency rate (meaning here loans that were 30+ days delinquent)

was 8.86 percent, for a combined rate of 13.13. “The delinquency rate includes

loans that are at least one payment past due but does not include loans

somewhere in the process of foreclosure.” Mortgage Bankers Association,

National Delinquency Survey 2009 2nd Quarter (Aug. 20, 2009). See also

Underwater and Not Walking Away

5

rate is not caused by large percentages of homeowners voluntarily

walking from their homes, even though they can afford the

payments. To the contrary, only about one-fourth of homeowner

defaults are strategic, with the other three-fourths triggered by job

losses, divorce or other financial difficulties, which when

combined with negative equity give homeowners no option but to

let go of their homes.13 In other words, for the vast majority of

homeowners, negative equity is a necessary but not a sufficient

condition for default. Moreover, the vast majority of defaults have

involved subprime14 or Alt-A loans15 – with over 47 percent of

subprime loans non-performing as of the second quarter of 2009.16

In contrast, the combined default rate for prime loans was only

5.44 percent.17 Put in perspective, these statistics mean that

though more than 32% of U.S. homeowners were underwater on

their mortgages by the end of the second quarter of 2009, the

strategic default rate was roughly 3%.18

Christopher L Foote,., Kristopher S. Gerardi, Lorenz Goette, and Paul S. Willen,

Reducing Foreclosures 5, Public Policy Discussion Papers, April 8, 2009

(noting that the empirical evidence on the role of negative equity in contributing

to foreclosures is “incontrovertible.”) Available at http://www.bos.frb.

Org/economic/ppdp/2009/ppdp0902.htm

13

Guiso et al., supra note 11, at 1; see News Release, Federal Housing

Finance Agency, FHFA Reports Fannie Mae and Freddie Mac Foreclosure

Prevention Efforts for May (Aug. 3, 2009),

http://www.fhfa.gov/webfiles/14723/MayForeclosure_Prevention8309.pdf

(noting that the top five reasons for delinquency are income loss (34%),

excessive obligations (20%), unemployment (8%), illness of principal mortgagor

(6%), and marital difficulties (6%).”)

14

A mortgage loan is subprime if the borrower has an imperfect credit

history and/or high debt-to-income ratio. “Subprime borrowers generally have a

credit (FICO) score between 580 and 660.” Drowning in Debt – A Look at

“Underwater” Homeowners 3, Deutsche Bank, August 5, 2009

15

Mortgage Bankers Association, National Delinquency Survey 2009

2nd Quarter (Aug. 20, 2009) “Alt-A loans were typically originated with

reduced documentation to home borrowers with limited credit history… Alt-A

borrowers have higher FICO scores (660-720) than subprime borrowers. Also,

relatively high concentrations of investor properties are common in

securitizations of Alt-A mortgage loans.” Drowning in Debt – A Look at

“Underwater” Homeowners 3, Deutsche Bank, August 5, 2009.

16

Laurie Goodman, et. al., Housing Overhang/Shadow Inventory =

Enormous Problem 8, Memorandum, Amherst Mortgage Insight, September 23,

2009 (on file with author)

17

Mortgage Bankers Association, National Delinquency Survey 2009

2nd Quarter (Aug. 20, 2009) However, as the subprime crisis has mostly run its

course, prime fixed-rate loans now account for one in three foreclosure starts.

Id.

18

Mortgage Bankers Association, National Delinquency Survey 2009;

and 1.9 Million Foreclosure Filings Reported on More than 1.5 Million U.S.

Properties in First Half of 2009, RealtyTrac, (July 15, 2009),

http://www.realtytrac.com/ContentManagement/PressRelease.aspx?channelid=9

&ItemID=6802 [hereinafter Foreclosure Filings Reported] . For a historical

Underwater and Not Walking Away

6

As further evidence that relatively few homeowners

strategically default solely because they are underwater, housing

markets with a sharply higher percentage of underwater

homeowners as compared to the national average do not have

sharply higher default rates. For example, although almost 51% of

Arizona homeowners were underwater (compared to 32%

nationally) in the second quarter of 2009, the combined foreclosure

and 30+ day deficiency rate in Arizona was 16.3% – only slightly

above the national average of 13%.19

As the chart below

illustrates, this pattern of relatively low default rates compared to

the percentage of underwater mortgages holds true almost

universally across the hardest hit markets, with the default rate

much more closely resembling the unemployment rate than the

percent underwater:

Metropolitan

Statistical Area Percent

underwater20 Serious

Delinquency

Rate

21

Unemployment

Rate

22

Merced, CA

85 18.99 17.5

Modesto, CA 84 15.10 16.1

Las Vegas-Paradise,

NV 81 15.53 11.3

Stockton, CA 81 16.20 15.5

Bakersfield, CA 79 11.92 13.9

Port St. Lucie, FL 79 17.30 14.1

Riverside-San

Bernardino-Ontario,

CA

78 15.19 13.7

Orlando-Kissimmee,

FL 71 16.63 10.7

Palm Bay-Melbourne-

Titusville, FL 69 10.92 11.1

Lakeland-Winter

Haven, FL 69 14.05 11.9

Phoenix-Mesa-

Scottsdale, AZ 68 10.09 7.7

Tampa-St. Petersburg- 65 11.71 11.2

comparison see Drowning in Debt – A Look at “Underwater” Homeowners

supra note ___ at 14 (noting that 7% of homeowners with negative equity

defaulted during the housing bust in Boston in the 1980’s and 90’s)

19

Mortgage Bankers Association, National Delinquency Survey 2009

2nd Quarter (Aug. 20, 2009)

20

Drowning in Debt – A Look at “Underwater” Homeowners 10,

Deutsche Bank, August 5, 2009

21

The seriously delinquent rate is the combined percentage of

mortgages more than 90 days delinquent or in foreclosure. Risk View: Spatial

Patterns of Mortgage Deliquency in Major U.S. Metropolitan Areas, First

American CoreLogic Newsletter, June 2009 (on file with author)

22

Update: The Outlook For U.S. Home Prices 24-25, Deutsche Bank,

June 15, 2009

Underwater and Not Walking Away

7

Clearwater, FL

West Palm Beach –

Boca Raton, FL 64 15.28 11.2

Salinas, CA 51 12.62 11.7

These numbers strongly suggest that factors other than

strategic defaults are driving the delinquency rate, with

unemployment the most likely culprit.23 Indeed, given the striking

disparity between the percentage of underwater homeowners and

the percentage of defaults, the real mystery is not - as media

coverage has suggested - why large numbers of homeowners are

walking away, but why, given the percentage of underwater

mortgages, more homeowners are not. 24

III. The Financial Logic of Walking Away

Before examining why more underwater homeowners are

not strategically defaulting, it might be helpful to explore why they

should. A textbook premise of economics is that the value of a

home, even an owner occupied one, is “the current value of the

rent payments that could be earned from renting the property at

23

See October Oversight Report: An Assessment of Foreclosure

Mitigation Efforts after Six Months, Congressional Oversight Panel 20-21

(discussing “fifth wave” of foreclosures caused by unemployment); Update: The

Outlook For U.S. Home Prices 9, Deutsche Bank, March 15, 2009 (on file with

author)(discussing the role of unemployment as the primary risk factor for

default).; and Alan Zibel, Foreclosures rise 5 percent from summer to fall,

ASSOCIATED PRESS WIRE, October 15, 2009 (on file with author)(reporting that

“Unemployment is the main reason homeowners are falling into trouble. While

the economy is likely out of recession, the unemployment rate — now at a 26-

year high of 9.8 percent — isn't expected to peak until the middle of next year.”)

Information for the Miami-Fort Lauderdale area is excluded from this chart due

to the high concentration of non-owner occupied investment properties in the

Miami-Fort Lauderdale area area, resulting in a deficiency rate more than double

the unemployment rate. See Kate Barry, Wary of Default, Banks Curtail Loans

to Investors, American Banker, October 13, 1009 (nothing that, many real estate

investors “in second-home markets” such as Miami . Las Vegas, and Phoenix

“simply turned in their keys to banks, defaulting on scores of second homes and

investment properties that they had intended to flip.”) See also Drowning in

Debt – A Look at “Underwater” Homeowners 10, Deutsche Bank, August 5,

2009 (listing underwater percentage for the Miami MSA of 70 percent and 69

percent for the Fort Lauderdale MSA); Risk View: Spatial Patterns of Mortgage

Deliquency in Major U.S. Metropolitan Areas, First American CoreLogic

Newsletter, June 2009 (on file with author) (listing serious delinquency rate for

the Miami MSA of 22.14 percent and 18.12 percent for the Fort Lauderdale

MSA); and Update: The Outlook For U.S. Home Prices 25, Deutsche Bank,

June 15, 2009 (listing unemployment rate in Miami of 8.5 percent and 9.3

percent in the Fort Lauderdale MSA).

24

For examples of the media hype regarding the purported walk away

phenomenon see, supra note 1.

Underwater and Not Walking Away

8

market prices.”25

In calculating whether to buy or rent, a potential

homebuyer should compare the net cost of owning to the net cost

of renting a similar home over the expected period of occupancy.

The costs of owning include the interest-only portion of the loan

payment, property taxes, maintenance, homeowners insurance, and

transaction costs upon selling, minus the expected appreciation and

cumulative tax savings over the planned period of ownership. As

a rule of thumb, a potential homebuyer is generally better off

renting when the home price exceeds 15 or 16 times the annual

rent for comparable homes.

In other words, when the net cost of buying a

home exceeds the net cost of renting, one is better off renting.

The equation is not as simple, however, as comparing total

mortgage payments to rent payments because home ownership

carries certain benefits including tax breaks and the potential for

appreciation. Additionally, assuming a non-depreciating market,

the portion of the mortgage payment that goes to principal rather

than interest will eventually inure to the homeowner at the time of

sale. On the flip side, homeownership carries significant costs

that renting does not, including maintenance, homeowner’s

insurance and substantial transaction costs upon selling.

26

The calculation for a rational homeowner in deciding

whether to strategically default on a home mortgage is similar to

that for buying in that base calculation is still the cost of renting

verses the cost of continuing to own.

27

However, the underwater

homeowner has additional considerations, including existing

negative equity on the one hand and the costs of foreclosure on the

other.28

25

HYE JIN RHO, ET. AL., CHANGING PROSPECTS FOR BUILDING HOME

EQUITY 3, (2008), available at

http://www.cepr.net/documents/publications/Changing_Prospects_for_Building

_Home_Equity_2008_10.pdf

Even leaving aside these foreclosure costs, the calculation

as to whether one is financially better off defaulting requires one to

consider several additional variables for which one may not have

good information. These variables include a reasonable estimate

of the current value of one’s home, the cost to rent a similar home,

an idea of how long one intends to stay in the home, and an

26

Id. at 4. Historical home prices have hewed to a price-to-annual-rent

ratio of roughly 15 to 1 - except during bubbles. Id.

27

As a caveat, for homeowners with sufficient resources to purchase

another home before bailing on the first, the calculation might actually be the

cost of buying a new home (rather than renting) verse continuing to own their

current home. See Nick Timiraos, Some Buy a New Home and Bail on the Old,

Wall St. J., June 11, 2008.

28

See, Joshua Rosner, Housing in the New Millennium: A Home

Without Equity is Just a Rental with Debt (June 29, 2001); available at SSRN:

http://ssrn.com/abstract=1162456 (discussing how lack of equity changes the

default calculation)

Underwater and Not Walking Away

9

estimate of the average appreciation or depreciation one’s home is

likely to experience over that period of time. While each variable

requires some guessing, there is a wealth of information available

to assist homeowners in making rational estimates – should they

endeavor to do so.29

With these estimates in hand, a homeowner also needs to

know the current principal balance on their mortgage(s), the

monthly interest-only portion of the mortgage(s), monthly

mortgage insurance, if any, the amount monthly taxes, insurance,

and homeowners association dues, if any, and their annual tax

savings from owning verses renting. A rational homeowner can

then make relatively simple calculations as to how much money

they would save or lose by walking away, both on a monthly basis

and over time. They can also predict out how long it will take to

recover their equity.

30

Consider, for example, Sam and Chris, a young

professional couple with two small children, who stretched to buy

their first home - an average 3 bedroom, 1380 square foot house in

Salinas, California – for $585,000 in January of 2006.

31

29

For example, both Zillow.com and the Home Price Calculator at

Sam and

Chris had excellent credit and a solid income, and were thus able

to qualify for a 30-year fixed interest loan with nothing down. At

http://www.fhfa.gov/ can provide most homeowners with a reasonably accurate

estimate of their home’s value. Or, if a home is particularly unique, one can

have their home appraised by professional appraiser. Similarly, one could have

a real estate management company give an estimate as to how much one’s home

would rent for or simply look in the newspaper and online to see what similar

homes are renting for. Moreover, there are considerable amounts of market-

specific research available on the internet which can help rational individuals

predict the amount of appreciation or depreciation their home is likely to

experience over a given period of time. See, e.g., HYE JIN RHO, ET. AL.,

CHANGING PROSPECTS FOR BUILDING HOME EQUITY (2008), available at

http://www.cepr.net/documents/publications/Changing_Prospects_for_Building

_Home_Equity_2008_10.pdf; Where Home Prices Are Hitting Bottom,

FORBES.COM, (September 18, 2009) http://www.forbes.com/2009/09/18/home-

prices-bottoming-lifestyle-real-estate-home-prices.html; and Why Housing

Hasn't Bottomed, FORBES.COM, (October 15, 2009)

http://www.forbes.com/2009/10/15/real-estate-ownership-markets-equities-

renting.html. Or a rational individual in a non-depreciating market might simply

count on appreciation around the historical home appreciation rate of 3-4% per

year. HYE JIN RHO, ET. AL, supra note 27.

30

For the mathematically challenged, there are online calculators, such

as one at YouWalkAway.com, that do these calculations automatically. See,

http://www.youwalkaway.com/output24/InterectiveFlashCalculator.html (last

visited Sep. 26, 2009).

31

This example is a hypothetical based upon the peak cost of an

average priced, and average sized, home in Salanis in January 2006. See Zillow,

Salinas Overview, http://www.zillow.com/local-info/CA-Salinas/r_54288/ (last

visited June 30, 2009)(listing 585,000 as the average home price in January

2006).

Underwater and Not Walking Away

10

an interest rate of 6.5%, their total monthly payment is $4300,32

Unfortunately for Sam and Chris, the housing market began

to collapse in 2007. Though they still owe about $560,000 on their

home,

which is just under 31% of their gross monthly income, and within

the payment-to-income ratio considered “affordable” by most

lenders. However, after paying for taxes, health insurance, student

loans, childcare, automobiles, food, and other necessities, Sam and

Chris do well to break even each month. At the time they bought

their home, they were not overly concerned about this - as they

saw their mortgage payment itself as an investment in their own

and their children’s futures.

33

it is now only worth $187,000.34 A similar house around

the corner from Sam and Chris recently listed for $179,000, which,

with a modest 5% down, would translate to a total monthly

payment of less than $1200 per month – as compared to the $4300

that they currently pay. They could rent a similar house in the

neighborhood for about $1000.35

Assuming they intend to stay in their home ten years, Sam

and Chris would save approximately $340,000 by walking away,

including a monthly savings of at least $1700 on rent verses

mortgage payments, even after factoring in the mortgage interest

tax reduction. The financial gain for Sam and Chris from walking

away would be even more substantial if they took their monthly

savings and put it into an investment account. If they stay in their

home on the other hand, it will take Sam and Chris over 60 years

just to recover their equity – assuming, of course, that they live that

long, the market in Salinas has indeed hit bottom, and their home

appreciates at the historical appreciation rate of 3.5%.

36

Millions of homeowners who bought homes in the last five

years are in similar situations to Sam and Chris, particularly in the

hardest hit states of California, Florida, Nevada, and Arizona. For

example, a homeowner who bought an average home in Miami at

32

This calculation assumes a loan of $585,000 at 6.5%, mortgage

insurance of $233, taxes $250, and homeowners insurance of $120. Id.

33

Calculation based upon amortization at 42 months, with

approximately $650 going toward principal each month. The remaining $3700

of the payment is interest, taxes and insurance.

34

This price is based upon Zillow data for Salinas, CA. Zillow, Salinas

Overview, http://www.zillow.com/local-info/CA-Salinas/r_54288/ (last visited

June 30, 2009)(indicating that the average home reached $585,000 in 2006 and

that the average home is now worth $187,000).

35

Based upon prices of homes currently listed for sale on Zillow in

Salinas, CA, id., and average rent identified in HYE JIN RHO, ET. AL., supra note

25

36

HYE JIN RHO ET AL. supra note 25 (indicating that historical

appreciation rates for home prices have been between 3% and 4%.)

Underwater and Not Walking Away

11

the peak would have paid around $355,400.37 That home would

now be worth only $198,00038 and, assuming a 5% down payment,

the homeowner would have approximately $132,000 in negative

equity.39 He could save approximately $116,000 by walking away

and renting a comparable home.40 Or, he could stay and take 20

years just to recover lost equity – all the while throwing away

$1300 a month in net savings that he could invest elsewhere. The

advantage of walking is even starker for the large percentage of

individuals who bought more-expensive-than-average homes in the

Miami area – or in any bubble market for that matter41 - in the last

five years. Millions of U.S. homeowners could save hundreds of

thousands of dollars by strategically defaulting on their

mortgages.42

Homeowners should be walking away in droves. But they

aren’t. And it’s not because the financial costs of foreclosure

outweigh the benefits. To be sure, foreclosure comes with costs,

including a significant negative impact on one’s credit rating.

43

But assuming one had otherwise good credit, and continues to

meet other credit obligations, one can have a good credit rating

again – meaning above 660 - within two years after a foreclosure.44

37

Zillow, Miami Home Prices, Home Values, and Property Values,

http://www.zillow.com/local-info/FL-Miami-home-value/r_12700/ (last visited

Sep. 7, 2009).

38

Id.

39

Id. (assumes 5% down with an interest rate at national average of

6.5% for June 2007).

40

Assumes monthly interest of $1824, mortgage insurance of $219,

taxes of $500, and homeowners insurance of $100, with $329,830 balance

remaining on the mortgage. The estimate for mortgage insurance is from

http://www.goodmortgage.com/Calc_PMI.htm.

41

See HYE JIN RHO, ET. AL., supra note 25, at 17 (listing“bubble

markets”).

42

Average national numbers show that home prices have declined 25%

nationally from $240,000 at the peak to $184,000 in June of 2009. See Zillow,

Real Estate Market Reports, http://www.zillow.com/local-

info/#metric=mt%3D34%26dt%3D1%26tp%3D5%26rt%3D14%26r%3D10200

1 (last visited Oct. 9, 2009).

43

Just how much impact a foreclosure has on one’s credit is unclear

because the Fair-Isaac Company will not share this information. But generally

one can expect a 100 to 150 point hit to his or her credit as a result of a

foreclosure, and additional hits for each late payment – which are generally

reported separately from the foreclosure itself. See How Foreclosures, Short

Sales, and Bankruptcies Affect Your Credit Score, AMERICAN BANKING NEWS,

Oct. 8, 2009, http://www.articlesbase.com/real-estate-articles/how-does-

foreclosure-impact-your-credit-report-234979.html. The total hit from late

payments and a foreclosure could be as much as 300 to 400 points.

Additionally, one must wait seven years before the foreclosure disappears from

one’s credit report entirely. Id.

44

See Marilyn Kennedy Melia, Life After Foreclosure, Bankrate.com,

http://www.bankrate.com/finance/mortgages/life-after-foreclosure-2.aspx (last

visited Oct. 9, 2009) (noting, “If a foreclosure is an isolated event on an

Underwater and Not Walking Away

12

Additionally, in as little as three years, one can qualify for a

federally-insured FHA loan to purchase another home.45

While the actual financial cost of having a poor credit score

for a few years may be hard to quantify, it is not likely to be

significant for most individuals – especially not when compared to

the savings from walking away from a seriously underwater

mortgage. While a good credit score might save an average person

ten of thousands of dollars over the course of a lifetime, a few

years of poor credit shouldn’t cost more than few thousand dollars.

Moreover, one who plans to strategically default can take steps to

minimize even this marginal cost. For example, one could

purchase a new vehicle, secure a new home to rent, or even

purchase a new house before beginning the process of defaulting

on one’s mortgage. Most individuals should be able to plan in

advance for a few years of limited credit.

There are, of course, costs to foreclosure other than

temporarily poor credit. These include moving costs and possible

transportation costs if one is required to live further from work or

school. But again, these costs are minimal when compared to the

savings of shedding a home that is hundreds of thousands of

dollars underwater. The most significant financial risk from a

foreclosure is the risk of a deficiency judgment or, in the

alternative, tax liability for the unsatisfied portion of one’s loan

upon foreclosure. But even these potential costs are significantly

less than one might expect. First, a number of states – including

many with the biggest declines in home values - are non-recourse

states, meaning that lenders may not pursue homeowners for a

deficiency judgment if the home was their primary residence.

Second, even in recourse states, lenders rarely pursue borrowers

for deficiency judgments unless they have special reason to suspect

otherwise good credit record, consumers may be able to rehabilitate their record

and garner better loans and card rates in 24 months”); see also

CreditScoreQuick.com, Revive Credit Report after Foreclosure,

http://www.creditscorequick.com/2008/03/revive-credit-report-after-

foreclosure.html (site last visited Sept. 26, 2009) (“Your credit report might

recover quickly as long as you have other good standing credit reporting on your

credit report.”)

45

CreditScoreQuick.com, Mortgages Fixes and Your Credit Score,

http://www.creditscorequick.com/2009/08/mortgage-fixes-and-your-credit-

scores.html (site last visited September 26, 2009). Because banks are often

much more willing to negotiate a short sale once it becomes clear that a

homeowner intends to default, strategically default need not result, and often

does not result, in a foreclosure. The negative effect of a short sale one’s credit

is significantly less than a foreclosure and depends on the negotiated agreement

between the borrower and the lender. For example, if the lender agrees to report

the loan as “paid,” there is no negative impact, whereas if the lender reports it

“settled,” the negative impact can be quite significant. Id.

Underwater and Not Walking Away

13

the borrower has means to pay it. 46 This is particularly true to the

extent that the home is in a state where lenders are overwhelmed

with foreclosures.47 Third, tax regulations have recently changed

to waive taxes on the unpaid portion of a mortgage upon

foreclosure, which was previously classified as income to the

borrower if the lender reported it as such.48

In short, the financial costs of foreclosure, while not

insignificant, are minimal compared to the financial benefit of

strategic default – particularly for seriously underwater

homeowners.

49

IV. Explaining Homeowner Choices

For many, default is the “in the money” option by

any objective measure. Yet most seriously underwater

homeowners aren’t walking away - even as they sink deeper into

negative equity.

It might be tempting to label such underwater homeowners

“woodheads,” a term sometimes applied in economic literature to

individuals who choose not to act in their own self-interest.50

46

See e.g., Oren Bar-Gill, The Law, Economics and Psychology of

Subprime Mortgage Contracts, 94 CORNELL L. REV. 1073 (2009) (finding that

even in recourse states, deficiency actions are often not cost-effective for the

lender, thus turning recourse loans into de-facto non-recourse loans)

But

labeling such behavior irrational does little to explain its existence.

One possible explanation is that the low rate of strategic default is

not the result of irrational decision-making at all, but rather the

result of utility maximizing calculations by homeowners. In other

words, it could be that underwater homeowners generally

understand that they could save hundreds of thousands of dollars

by defaulting on their mortgages, but they simply value their

homes (in which they may have “made large financial, emotional,

47

See Peter S.Goodman, Paper Avalanche Buries Plan to Stem

Foreclosures, N.Y. TIMES, June 29, 2009,

http://www.nytimes.com/2009/06/29/business/29loanmod.html

48

The Mortgage Debt Relief Act of 2007 excludes income from the

discharge of debt on principal residences. Debt reduced through mortgage

restructuring, as well as mortgage debt forgiven in connection with a

foreclosure, qualifies for the relief. This provision applies to debt forgiven in

calendar years 2007 through 2012.

49

As discussed above, a significant portion of homeowners fall into the

“seriously underwater” category. For example, 47% percent of homeowners in

Nevada had negative equity exceeding 25% of their home’s value, as did 30% of

homeowners in Florida, 29% in Arizona, and 25% in California. First American

CoreLogic, Negative Equity Report (Aug. 13, 2009). Given the high median

home prices at the peak within these markets, a large percentage of these

homeowners are underwater by hundreds of thousands of dollars.

50

See, e.g., Deng & Quigley, supra note Error! Bookmark not

defined., at 3-4

Underwater and Not Walking Away

14

and psychological investments”) more than the market does.51

The “market value” of a home may be, for example, $198,000, but

it could be worth $355,000 to the homeowner – indeed why else

would they pay that much for it in the first place.52 Additionally,

homeowners as a class may be risk adverse, meaning that they

value the security of their good credit and of knowing they will not

suffer a deficiency judgment or a large tax bill (even if the risk of

either is low) over the money that they could save by defaulting.

Finally, homeowners as a class may value not having to move

more than they value the thousands they could save by walking

away and renting.53 As one economist has argued, “The so-called

underexercise of the default option, therefore, is actually rational

behavior without transaction costs....”54

This explanation naïvely – or deliberately - ignores much

of the cognitive sciences tell us about how humans actually make

decisions. As behavioral economists understand, humans make

decisions in ways that are less than fully rational – but are

understandable given the ways that humans (mis)perceive and

(mis)process information.

55

On a basic level, most humans have

difficulty doing mathematical calculations and are easily

overwhelmed, for example, by the variety of factors that one must

consider in deciding the financial benefits and costs of strategically

defaulting.56

51

See Ross, infra note

Humans are also susceptible to what behavioral

economists call the status quo bias – or the tendency to keep one’s

70, at 9 (noting “individuals had made large

financial, emotional, and psychological investments in their home.”)

52

See Paul Krugman, How Did Economists Get it so Wrong, N.Y.

TIMES, September 2, 2009 (discussing a general belief among neoclassical

economists “that bubbles just don’t happen” and quoting Eugene Fama, “the

father of the efficient-market hypothesis,” as follows: “the word ‘bubble’ drives

me nuts... Housing markets are less liquid, but people are very careful when they

buy houses. It’s typically the biggest investment they’re going to make, so they

look around very carefully and they compare prices. The bidding process is very

detailed.” ).

53

For support of such a suggestion, see Ross, infra note 70, at 10

(discussing the ontologicial security of homeownership, arguing that “the home

offer[s] individuals a sense of order, continuity, and place or physical

belonging.”)

54

Kerry D. Vandell, Handing Over the Keys: A Perspective on

Mortgage Default Research, 21 J. AM. REAL ESTATE & URBAN ECON. ASS’N

211, 236 (1993).

55

See e.g., Bar-Gill, supra note 46, at 40 (discussing the affects of

human limitations on attention, memory, and processing ability which lead to

less than rational decisions, such as simply ignoring critical details in mortgage

contracts, when confronted with complex calculations).

56

See e.g., Ubel, supra note 3 (positing that human nature when

confronted with financial decisions involving detailed mathematics is to

disregard legitimate financial fears and follow the advice of others, such as real

estate agents).

Underwater and Not Walking Away

15

head in the sand.57 This bias means that even those humans who

could do complex calculations if they wanted to, usually don’t.

Moreover, humans suffer from other cognitive biases such as

myopia, or the tendency to overvalue up-front cost and undervalue

long-term gain.58

Additionally, like all human beings, homeowners suffer

from selective perception,

Thus, most underwater homeowners may fail to

cognitively grasp the full benefit of strategic default.

59

which causes them to fail to see

evidence – such as actual prices of sold homes in their

neighborhood – that would suggest a steep fall in their home’s

value.60 Instead, they see contrary indicators such as the list prices

of overpriced homes in their neighborhood, which taken out of

context suggest that prices have not fallen significantly. Selective

perception also causes homeowners to fail to attend to estimates on

websites such Zillow.com or fhfa.gov that show their home’s

declining value and to discount media reports of step price declines

as somehow inapplicable to their unique home, or their special

neighborhood.61 Relatedly, homeowners tend toward optimistic

overconfidence,62 – believing, for example, that home prices will

bounce back in a few years and that their homes will soon be worth

more than they paid.63

57

William Samuelson & Richard Zeckhauser, Status Quo Bias in

Decision Making, 1 J. RISK & UNCERTAINTY 7 (1988); see also Mario J. Rizzo

& Douglas Glen Whitman, Little Brother is Watching You: New Paternalism on

the Slippery Slopes, 51 ARIZ. L. REV 685, 686 (2009).

Indeed, selective perception may have

caused many homebuyers to ignore signs of the impending housing

market collapse in the first place - and optimistic overconfidence

may have caused many homeowners to take out interest-only

ARMs in the misplaced belief that they would have better salaries

58

See R.H. Strotz, Myopia and Inconsistency in Dynamic Utility

Maximization, 23 REV. ECON. STUD. 165 (1955-56); Lester C. Thurow, Cash

Versus In-Kind Transfers, 64 AM. ECON. REV. 190 (1974); see also Barak Y.

Orbach, Unwelcome Benefits: Why Welfare Beneficiaries Reject Government

Aid, 24 LAW & INEQ. 107, 122 (2006).

59

Ubel, supra note 3 (labeling the human susceptibility to selective

perception as “unrealistic optimism”).

60

See Housing Over-Confidence, INVESTORS CHRON., Apr. 27, 2009

(noting, “On hearing that a neighbour's house has sold for a low price, our

reaction is often: ‘But our house is much more presentable than theirs.’

Everyone thinks they are Sarah Beeny. But they are not.”)

61

Id. (discussing the fact that, due to optimistic overconfidence, sellers

generally fail to adequately take price declines into account when setting list

prices.”)

62

Ubel, supra note 3 (noting that due to “unrealistic optimism”

homeowners over-estimated the future growth of their salaries and home

values).

63

An analogy here would be the reluctance of many investors to sell a

share that drops significantly in value after they bought it and wait in hopes that

the share will climb back up to the initial purchase price – even though there

may be little hope of it doing so.

Underwater and Not Walking Away

16

in a few years, or would refinance as their home’s value grew

exponentially.64

There is certainly much in this behavioral economic

account that helps explain the choices of underwater homeowners.

Many homeowners do tend to overvalue their homes, particularly

if they bought them during booms.

65

Many homeowners also have

their head in the sand, preferring to focus on things that they

believe they can control rather than things that they believe they

cannot.66

On the other hand, labeling the status quo bias, selective

perception, and optimistic overconfidence as “cognitive biases,”

doesn’t account for the way in which emotions unconsciously

color the perceptions of individuals who want, or need, to believe

something – including, for example, that their house is worth what

they paid.

67

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.68

64

See Housing Over-Confidence, supra note 59 (discussing distorting

effect on prices of the irrational belief that house prices would continue to rise.)

65

See Id. (noting that: “The average person over-estimates the price of

their house by between five and ten per cent. But there's variation around this

average. Whereas people who bought in recessions tend to value their houses

accurately, those who bought in booms are even more over-optimistic,

overvaluing their properties by up to 20 per cent.” And further explaining that:

“There are strong cognitive biases causing this - and not just plain wishful

thinking. One is the availability heuristic effect. If your biggest exposure to

housing market economics came when you bought during a boom - and of

course, many more people buy in booms than slumps - rapid house price

appreciation will loom large in your mind. This will cause you to over-estimate

its size and frequency, and so over-estimate your own house price.”)

66

If one accepts that homeowner decisions are the result of cognitive

biases, the solution to helping homeowners make better decisions – should

policy makers or others actually wish to encourage rational economic behavior

by underwater homeowners – is to help homeowners think better. This means

providing better information, helping homeowners calculate the benefits and

costs of default, and pointing out the cognitive biases that cloud their thinking.

Under this line of thinking, homeowners just need a little help in order to behave

more rationally.

67

See Christopher Merkle, Emotion and Finance - An Interdisciplinary

Approach to the Impact of Emotions on Financial Decision Making 14-15

(Working Paper, Feb. 28, 2007), available at http://ssrn.com/abstract=1097131

(“feelings act as a selective attentional filter for incoming stimuli. The strong

immediate experience of emotion may lead to a crowding out of other goals.

Secondly emotion influences the retrieval of information and knowledge from

memory.”). See also Zajonc at 157.

68

See e.g., Ralph D. Ellis & Natika Newton, Introduction

(summarizing collected papers addressing influence of emotion on perception),

in CONSCIOUSNESS & EMOTION: AGENCY, CONSCIOUS CHOICE, AND SELECTIVE

PERCEPTION ix, x-xi (Ralph D. Ellis & Natika Newton eds., 2005); R.B. Zajonc,

Feeling and Thinking: Preferences Need No Inferences, 35 AM. PSYCHOLOGIST

151, 155 (1980); John A. Bargh and Tanya L. Chartrand, The Unbearable

Underwater and Not Walking Away

17

In other words, when one is consciously or unconsciously

motivated to reach a certain conclusion, the brain’s emotion

systems focus awareness on information that is congruent with

one’s emotional need and directs the conscious to ignore,

reinterpret, or discount incongruent information.69 As such, if a

homeowner is not emotionally receptive to the idea that their home

is worth thousands less than they paid, it may be next-to-

impossible to convince him that he is underwater in the first place,

much less that it will take 20 years just to recover lost equity.70

Similarly, if a homeowner places great emotional stock in his

credit score, it may be futile to try to convince him that a few years

of a poor credit is not a big deal. Indeed, trying to persuade the

homeowner that he is wrong is likely to make him stick even more

firmly to his prior beliefs.71

Thus, if one is to understand how homeowners think, one

must understand how they feel. Most mortgage default risk

modeling fundamentally fails to appreciate this point and more

generally does not account for the primacy of emotion in driving

human behavior and decision-making. This may not matter if the

goal is to merely describe or model observable human behavior,

but it does matter to the extent that policymakers and others are

interested in encouraging individuals to make different choices –

Automaticity of Being, 54 AM. PSYCHOLOGIST 7 (1999). See also, David P.

Redlawsk, Motivated Reasoning, Affect, and the Role of Memory in Voter

Decision Making, in FEELING POLITICS: EMOTION IN POLITICAL INFORMATION

PROCESSING (David P. Redlawsk ed., 2006); (noting that “Emotion “may

indeed, be the primary vehicle implicated in motivated reasoning, leading to

selective attention, information distortions, and recall biases.”); Merkle, supra

note 64 (“Attention is focused on aspects of a situation that are consistent with

the prevailing emotion, what may result in different estimations of probabilities

for certain events or a different rating of an alternative’s global attractiveness.”);

Terry Maroney, Law and Emotion: A Proposed Taxonomy of an Emerging

Field, 30 (2) LAW AND HUMAN BEHAVIOR 119 (2006) (noting that, “First,

emotion can influence both which stimuli are perceived and how they are

perceived. This is first seen through the mechanism of attention. Because

emotionally salient stimuli tend to be the ones of greatest significance to one's

thriving, they will be attended to disproportionately.”).

69

See Milton Lodge, Charles Taber & Christopher Weber, First Steps

Toward a Dual-Process Accessibility Model of Political Beliefs, Attitudes, and

Behavior, in FEELING POLITICS, supra note 66.

70

Lauren Ross, The Internal Costs of Foreclosure 38, August 31, 2009

(unpublished thesis) (on file with author) (noting that “[m]any individuals are

reluctant to acknowledge that the housing and mortgage markets have

significantly changed and are no longer wholly sustainable or lucrative

investments.”).

71

David P. Redlawsk, Feeling Politics: New Research into Emotion and

Politics, in FEELING POLITICS, supra note [x], at 1 (explaining that individuals

often end up feeling stronger than they did before being confronted with

information that would have been expected, under rational models of belief

formation, to cause them to reassess their existing beliefs).

Underwater and Not Walking Away

18

or to continue to make the same choices for that matter. In most

studies of homeowner decision-making, however, emotions are

treated as an x-factor to be calculated around in figuring out how

other varying factors affect individual choice and market

behavior.72 Emotion is rarely considered in and of itself as a

primary factor motivating both people and markets. For example,

default risk analysts have studied the relationships between initial

loan-to-value and mortgage default,73 current equity and mortgage

default, affordability and mortgage default,74 credit scores and

mortgage default,75 geography and mortgage default,76 and

unemployment and mortgage default77 – to name a few. But

researchers have shown little interest in the relationship between

guilt and mortgage default.78

The neglect of emotion is particularly intriguing given the

recent work of Luigi Guiso, Paola Sapienza, and Luigi Zingales,

which found that 81% of homeowners believe that it is immoral to

default on a mortgage, and that homeowners who hold this attitude

are 77% less likely to declare their intention to default than those

who do not.

Nor have they shown any interest in

the relationship between fear and mortgage default.

79

72

See Vandell, infra note 165, at 236 (pricing models “all assumed

ruthless default whenever the value of the mortgage dropped below the value of

the property” and ignored “psychological costs.”); and See Foote, et. al., supra

note 14 at 5 (explaining that in their default prediction model the probability of

default, guilt, shame, and reduced access to future credit were calculated around:

“We assume that the decision to default costs the borrower some amount !"#$%!

period, which can be interpreted as some combination of guilt, shame, and

reduced access to future credit.”)

Indeed, once the equity shortfall exceeds 10% of a

home’s value, the study found that “moral and social

considerations” are the “most important variables predicting

73

Yongheng Deng, John M. Quigley, & Robert Van Order, Mortgage

Terminations, Heterogeneity and the Exercise of Mortgage Options,

ECONOMETRICA 275 (2000) (showing that higher default risk is related to higher

initial LTV’s).

74

See Foote, et. al., supra note 14 at 3-13.

75

Satjajit Chatterjee, Dean Corbai, & José Victor Ríos-Rull, Credit

Scoring and Competitive Pricing of Default Risk (unpublished and incomplete,

Jan. 2007), available at http://pier.econ.upenn.edu/Events/scorevictor.pdf.

76

Deng, Quigley, & Van Order, supra note 71 at 23.

77

Id. at 17 (finding that trigger events, such as unemployment and

divorce have significant impact on homeowners’ exercise of the default option).

78

While it may seem obvious that one who feels guilty about the idea

of defaulting will be less likely to do so, it is equally obvious that those with

high loan-to-value ratios, the unemployed, and individuals with low credit

scores will be more likely to default. But economists study these things anyway

in order to determine how much they matter and how predictive they are of

mortgage default. Such information is used by economists to assist lenders in

assessing risk and pricing mortgages, but it also informs public policy by

purporting to illuminate the most efficient ways to reduce foreclosures.

79

Guiso et al., supra note 11, at 21.

Underwater and Not Walking Away

19

strategic default.”80 So strong are these variables, in fact, that only

17% of homeowners indicted that they would default if the equity

shortfall reached 50%.81 On the other hand, the study found that

people who know someone who has strategically defaulted are

82% more likely to declare their intention to do so.82 The authors

thus caution that “a policy aimed at helping people in arrears with

their mortgage could have devastating effects on the incentives to

strategically default of people who can afford to pay their

mortgage if it is perceived to bail out people unjustly and thus

undermine the moral commitment to pay.”83

While the study sheds important light on the role of social

and moral constraints in the default decision, its conclusion also

highlights the problem with crafting public policy from studies that

do not try to understand why people act the way that they do.

Perhaps the authors are right--perhaps people will respond to loan

modification programs for those who can no longer afford their

mortgages by defaulting on their own mortgages--but there is no

evidence to suggest that this is the case. One might just as easily

assert that the failure of banks to modify loans for individuals in

need, while banks themselves have been bailed out by the federal

government, will cause individuals to conclude that they should

forget about morals and just look out for their own self-interests.

84

In order to know whether either of these assertions is true, one

needs to understand how moral beliefs and attitudes are formed,

and one needs to understand how humans make decisions. And, as

evidence from the cognitive sciences convincingly demonstrates,

emotion is primary to both.85

The Guiso, Sapienza, and Zingales article does however

confirm something that policy makers and lenders already know

80

Id. at 21-22.

81

Id. at 15.

82

Id. at 6.

83

Id. at 3. Indeed, one thrust of the paper is that the Obama

administration’s plan to encourage modification of loans to make them more

affordable is misguided - and likely to backfire. Id. at 21.

84

For an example of one individual who feels this way, see the web

posting of L. Serbanescu at Economist.com, available at

http://www.economist.com/businessfinance/displayStory.cfm?story_id=139055

02&mode=comment&#commentStartPosition (writing that “[t]he financial

system created the house market bubble, putting everyone that wanted a house

in the uncomfortable position of paying inflated prices. The financial

establishment made tons of money in the process....Now that ditching a

mortgage makes economic sense for a homeowner, The Economist discovers

that such behavior is immoral…Why should anyone be morally obliged to

continue to pay them at a loss?”).

85

R.B. Zajonc, Feeling and Thinking: Preferences Need No

Inferences, 35 AM. PSYCHOLOGIST 151, 155 (1980); John A. Bargh and Tanya

L. Chartrand, The Unbearable Automaticity of Being, 54 AM. PSYCHOLOGIST 7

(1999).

Underwater and Not Walking Away

20

and use to their advantage: people are less likely to default if

doing so will make them feel like immoral or irresponsible persons

– and are especially unlikely to default if they believe others will

think of them as immoral or irresponsible persons.86 Guilt and

shame are powerful motivators,87 and there is no doubt that many

people who have faced foreclosure feel a great deal of both.88

As Linda, a single mom in Tampa who asked that her last

name not be used, explained, "As a mom, I feel like I let my

children down… It's a terrible embarrassment, and it's

humiliating.”

89

Linda is not alone: a recent qualitative sociological

study of the internal costs of foreclosure found that feelings of

personal failure, shame, and embarrassment dominated the

accounts of individuals who had lost their homes to foreclosure.90

Moreover, such feelings predominated even when individuals were

not at fault for their predicament, but were victims of the declining

economy and/or unethical practices by mortgage brokers.91

86

Guiso et al., supra note 11, at 8 (stating that “[m]oral considerations,

if widespread, may strongly mitigate the likelihood that American households

will default on their mortgage”). Research in social psychology has shown that

humans invest significant emotional stake in “face” – or their “claimed identity

as a competent, intelligent, or moral persons” - and will go to great lengths to

avoid actions which publically threaten this identity. See Holley S. Hodgins &

Elizabeth Liebeskind, Apology Versus Defense: Antecedents and Consequences,

39 J. EXPERIMENTAL SOC. PSYCHOL. 297, 297 (2003).

And,

87

See Danielle Einstein and Kevin Lanning, Shame, Guilt, Ego

Development, and the five-factor model of personality, 66 JOURNAL OF

PERSONALITY 555 (1998) (explaining that guilt and shame are negative affective

states which act as moral voices guiding social activity of individuals).

88

See Ross, supra note 68 (“The notion of guilt ascription was also

central to these findings. Although many individuals recounted the exact ways in

which they were “misled” in their loan negotiations, they often returned to the

idea of being personally responsible for their actions.”).

89

Judi Hasson, Homeowners Who Just Walk Away, MSN MONEY,

http://articles.moneycentral.msn.com/Banking/HomeFinancing/HomeownersWh

oJustWalkAway.aspx (last visited Oct. 9, 2009).

90

See Ross, supra note 68, at 37

91

See id. at 35. One woman in the study described her sense of

“utmost responsibility to make her monthly payments on time” as follows:

I made a commitment to pay my loan and I want to pay my

loan. I’m a hard working person and I want to make good on

my loan, but there’s no way I possibly can in the situation the

economy’s in right now.

Others expressed concern over being perceived as “irresponsible

citizens’ or “burdens on society:”

And um so I’m just, I’m kind of interested in the public

perception. You know I don’t want to be a burden on the rest

of society because I’m not paying my mortgage. Now there’s

Underwater and Not Walking Away

21

as further evidence of the shame and guilt felt by those who

experience foreclosure, large damage awards for humiliation are

common features of successful suits against lenders for wrongful

foreclosure.92

While no study to date has sought to quantify the role of the

desire to avoid guilt and shame in underwater homeowners’

decisions not to strategically default, more general studies on the

role of guilt and shame in motivating human behavior suggest a

significant impact.

93

this big giant bailout and I’m involved in that. You know, my

mortgage was one of the mortgages not being paid.

The desire to avoid guilt and shame cannot,

however, completely explain the reluctance of homeowners to

92

See, e.g., Levine v. First Nat. Bank of Commerce, 917 So.2d 1235,

05-106 (La.App. 5 Cir. 2005) (holding “evidence was sufficient to support

award to mortgagor of $150,000 for humiliation and embarrassment and

$150,000 for mental anguish); Clark v. West, 395 S.E.2d 884 (Ga.App., 1990)

(holding “[m]ortgagor's obtaining cancellation of foreclosure sale in equitable

action did not bar her from pursuing separate claim of damages for humiliation

and emotional distress for the alleged intentional, wrongful foreclosure by

mortgagees); Carter v. Countrywide Home Loans, 2009 WL 1010851 (E.D.Va.

2009) (allowing claims for “humiliation and damage to reputation” due to

wrongful foreclosure under the Real Estate Settlement Procedures Act

(“RESPA”), 12 U.S.C. § 2601 et seq., and the Fair Debt Collection Practices Act

(“FDCPA”), 15 U.S.C. § 1692 et seq.,); Mason v. Chase Bank of Texas, N.A.,

2008 WL 3412212 (Tex.App.-Dallas 2008) (claim for humiliation from

attempted foreclosure); Brannon v. Bridge Capital Corp., 2008 WL 2225791

(M.D.Ala., 2008) (discussing plaintiff claim that “foreclosure publishings

caused him embarrassment and humiliation); Lee v. Javitch, Block & Rathbone,

LLP, 2008 WL 1886178 (S.D.Ohio 2008) (humiliation from wrongful

foreclosure recoverable under the FDCPA); Cushing & Dolan, PC v. National

Lenders, Inc., 2004 WL 2712208 (Mass.Super., 2004) (claim for “humiliation”

due to “public notices of foreclosure on their home and the inspection of their

home by potential buyers, lawyers, and auctioneers.”); Volk v. Wisconsin

Mortg. Assur. Co., 474 N.W.2d 40 (N.D. 1991) (claiming damage to plaintiffs

“personal reputation, credit rating, financial reputation, unfavorable publicity,

embarrassment, humiliation, and ridicule caused by the foreclosure action.”);

and Union Federal Sav. Bank v. Hale, 1993 WL 488399 (Ohio App. 9 Dist.

1993) (defendant in foreclosure action averring that “as a result of Plaintiff's

wrongful refusal to accept the aforementioned mortgage payments, I have

suffered damage to my credit rating and reputation; emotional distress, anxiety,

embarrassment, humiliation and worry….”).

93

See e.g., CARROLL E. IZARD, HUMAN EMOTIONS, (New York:

Plenum 1977)(explaining that guilt is the primary motivational factor in a

mature conscience); Dwight Merunka , et. al., Modeling and Measuring the

Impact of Fear, Guilt and Shame Appeals on Persuasion for Health

Communication: a Study of Anti-Alcohol Messages, Working paper

(2009)(finding that “Shame motives social behavior and leads to conformity to

social norms.”); and Damien Arthur and Pascale Quester, Who’s Afraid of that

Ad? Applying Segmentation to the Protection Motivation Mode, 21

PSYCHOLOGY AND MARKETING 671 (2004) (demonstrating the importance of

fear, guilt, and shame in determining behavior).

Underwater and Not Walking Away

22

default. Indeed, the Guiso, Sapienza, and Zingales study found

that only 41% of individuals who no moral issue with strategic

default would strategically default at $100,000 in negative

equity.94 The question is thus: what keeps the other 59% from

walking? Guiso, Sapienza, and Zingales theorize that even amoral

people may be deterred from defaulting by the social stigma that

comes with foreclosure.95 They are probably right – up to a point.

But their study did not actually ask these “amoral” individuals

what keeps them from walking. At some point – if not $100,000

then $200,000 (where 41% of the “amoral” individuals still would

not walk)96

Moreover, foreclosure rates are considerably lower than

would be suggested by the Guiso, Sapienza, and Zingales study, as

the percentage of people who actually default is much lower than

the percentage that indicated they would default in the survey,

moral qualms or not. For example, the study found that 26% of

individuals would default at $100,000 in negative equity and 41%

would do so at $200,000.

- social stigma alone becomes an unconvincing

explanation.

97

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.”

But given the number of homeowners

that are significantly underwater, one would expect foreclosure

rates should be higher if this were the case.

98

As one commentator on foreclosure has noted, “foreclosure is that

terrifying word no homeowner ever wants to hear, let alone

experience.”99

94

Guiso et al., supra note

People not only fear losing their homes, but fear

having ruined credit for life, not be 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

11, at 10.

95

Id. at 8.

96

Id. at 17.

97

Id. at 17.

98

John Leland, Facing Default, Some Walk Out on New Homes, N.Y.

TIMES, Feb. 29, 2008 (homeowner reporting being “terrified” by foreclosure);

Las Vegas Military Wife Fights to Save Home, LAS VEGAS NOW

http://www.lasvegasnow.com/Global/story.asp?S=10965954 (describing

“terrifying” fight to save home); and Chris Isidore, Homes in Foreclosure Top 1

Million, CNNMONEY, June 5, 2008,

http://money.cnn.com/2008/06/05/news/economy/foreclosure/index.htm?postver

sion=2008060510 (describing foreclosure as terrifying).

99

See Jenny Greenleaf, About Foreclosure Law, eHow,

http://www.ehow.com/about_4571547_foreclosure-law.html (last visited Oct. 9,

2009) (noting, “Foreclosure is that terrifying word no homeowner ever wants to

hear, let alone experience”).

Underwater and Not Walking Away

23

one knows it: financial suicide to be avoided at all costs.100 In

short, fear – like shame and guilt - is a powerful motivator in

homeowner decisions not to default.101

Further empirical study is necessary to qualify the

statistical significance of shame, guilt, and fear in homeowner

decisions to strategic default. But all three play a critical role in

motivating human behavior and deserve further academic study in

the mortgage default context.

102

Academics and non-academics

alike, however, intuitively understand the power of these emotions

to control human behavior. As such, those who benefit from

underwater homeowner decisions not to default have not waited to

for statistical proof of the efficacy of those emotions to cultivate

them.103

V. The Social Control of the Housing Crisis

A concern repeatedly voiced by policy makers, economists,

and the media is that the “social pressure not to default will

weaken” to the point homeowners will begin to walk in droves.104

100

Of course, to argue that homeowner decisions not to default are

motivated by fear is not to suggest that cognitive biases play no role. The two

are not mutually exclusive – but are mutually reinforcing. Much homeowner

fear is driven by the misperception or overestimation of the future costs

associated with foreclosure – and this fear in turn leads to further selective

perception and/or wishful thinking about the probability of housing prices

returning to previous levels.

Of particular concern is the contagion effect, the notion that once a

101

See e.g., Damien Arthur and Pascale Quester, 2004, Who’s Afraid of

that Ad? Applying Segmentation to the Protection Motivation Mode, 21

Psychology and Marketing 671 (2004) (confirming the positive relationship

between fear and persuasion); Michael S. LaTour and Herbert J. Rotfeld, There

are Threats and (May be) Fear-Caused Arousal: Theory and Confusions of

Appeals to Fear and Fear Arousal Itself, 26 JOURNAL OF ADVERTISING

45(1997)(confirming that fear motivates behavior); Irving L. Janis and Seymour

Freshbach, Effects of Fear-Arousing Communications 48 JOURNAL OF

ABNORMAL AND SOCIAL PSYCHOLOGY 78 (1953) (finding that fear appeals

influence attitudes and behavior).

102

For studies of the role of guilt, shame and fear in motivating

behavior in other contexts, see e.g., Damien Arthur and Pascale Quester, supra

note 97 (demonstrating the power of negative emotions of fear, guilt, and shame

in marketing) and Ken Chapman, Fear Appeal Research: Perspectives and

Application, 3 AMERICAN MARKETING ASSOCIATION SUMMER EDUCATOR’S

CONFERENCE PROCEEDINGS 1 (1992) (finding that that negative emotional

responses significantly influences individual behavior)

103

See Rashmi Dyal-Chand, Human Worth as Collateral, 38 RUTGERS

L.J. 793 (2007) (noting “[c]redit card lenders, on the other hand, do seem to

recognize the power of shaming their borrowers, though they may not explicitly

describe it as such”).

104

Guiso et al., supra note 11, at 22; Id. at 2 (reporting that “strategic

defaults may produce contagion effects”).

Underwater and Not Walking Away

24

few people in a neighborhood walk, others will follow, until whole

neighborhoods end up as empty wastelands.105 Indeed,

geographical patterns already show that foreclosures cluster in

neighborhoods,106

Alarmed by the possibility that foreclosures may reach a

tipping point, formal federal policy has aimed to stem the tide of

foreclosures through programs designed to “reduce household cash

flow problems,” such as the Making Home Affordable (MHA)

loan modification program

suggesting that once foreclosure is seen as

acceptable within a given community, and an individual knows

others who have survived foreclosure, there may be less reason to

feel ashamed of one’s decision to walk or to fear the consequences.

107

and Hope For Homeowners.108

Implicit in this approach is the assumption that home owners are

unlikely to default on their mortgage if they can “afford”109 the

monthly payment. In other words, federal policy assumes that

homeowners are – for the most part - not “ruthless” and won’t

walk away from their mortgages simply because they have

negative equity.110

105

Guiso et al., supra note

Most homeowners walk only when they can no

longer afford to stay. As evidence of this fact, only 45% of

homeowners would walk even if they had $300,000 in negative

11, at 20; John P. Harding, Eric Rosenblatt,

& Vincent W. Yao, The Contagion Effect of Foreclosed Properties, J. OF URB.

ECON. 21 (2008), available at http://ssrn.com/abstract=1160354 (noting that

“nearby distressed property has a significant, negative effect on the prices of

nearby homes over and above the overall trend in market prices”).

106

Guiso et al., supra note 11, at 6.

107

See Making Home Affordable,

http://makinghomeaffordable.gov/about.html (last visited Oct. 9, 2009)

(explaining that the Making Home Affordable program aims “to strengthen the

national economy by providing homeowners whose homes have decreased in

value, thereby inhibiting their ability to refinance to a lower rate within the

private sector, with a more affordable monthly option for their mortgage

payments….”).

108

See Hope for Homeowners,,

http://www.hud.gov/hopeforhomeowners/ (last visited Oct. 9, 2009). The

HOPE website describes the program as follows:

Under the program, borrowers having difficulty paying their

mortgages will be eligible to refinance into FHA-insured

mortgages they can afford. For borrowers who refinance under

HOPE for Homeowners, lenders will be required to "write

down" the size of the mortgage to a maximum of 90 percent of

the home's new appraised value.

109

Guiso et al., supra note 11, at 19.

110

See ROBERT AVERY ET. AL., CREDIT RISK, CREDIT SCORING, AND

THE PERFORMANCE OF HOME MORTGAGES (1996), available at

http://www.federalreserve.gov/pubs/bulletin/1996/796lead.pdf (noting that

credit risk models reflect fact that few borrowers are “ruthless”).

Underwater and Not Walking Away

25

equity. 111 This percentage drops to 38% among the subset of

individuals who believe it is immoral to strategically default on

one’s mortgage (a subset to which 87% of homeowners belong).112

These numbers suggest that the “moral constraint” is a

powerful one indeed – and that, for most people, only the complete

inability to afford their mortgage would push them to default. On

the other hand, the fact that 63% of “amoral” individuals would

default at $300,000 in negative equity, and 59% would do so at

$200,000,

113

This is not to say that there is a grand scheme to manipulate

the emotions of homeowners, or even that the government and

other institutions consciously cultivate these emotional constraints

on default.

suggests that federal policy can only proceed on the

premise that affordability is the prime consideration as long as the

moral and social constraints on foreclosure remain strong. The

government thus has an incentive, along with certain other

economic and social institutions interested in limiting the number

of foreclosures, in cultivating guilt and shame in those who would

contemplate walking away. Similarly, knowing that guilt and

shame alone are not enough to prevent many individuals from

defaulting once negative equity is extreme, these same institutions

have an interest in increasing the perceived cost of foreclosure by

cultivating fear of financial disaster for those who contemplate it.

114

But, to be sure, the predominate message of

political, social, and economic institutions in the United States has

functioned to cultivate fear, shame, and guilt in those who might

contemplate foreclosure. These emotions in turn function as a

form of internalized social control –encouraging conformity to the

norm of meeting one’s mortgage obligations as long as one can

afford to do so.115

The clear message to American homeowners from nearly

all fronts is that one has a moral responsibility to pay one’s

mortgage. The message is conveyed not only by political, social,

and economic institutions, but by the majority of Americans who

believe that voluntarily defaulting on a mortgage is immoral. At

the political level, government spokespersons, including President

Obama, have repeatedly emphasized the virtue of homeowners

who have acted “responsibly” in “making their payments each

111

See generally Guiso et al., supra note 11.

112

Id.

113

GUISO ET AL., supra note 11, at 10.

114

Social control is defined by most contemporary scholars “as

attempts, whether intentional or not, by the state or social institutions to regulate

or encourage conformity to a set or norms through socialization or the threat of

coercion, or both,” David Pearce Demers and K. Viswanath, MASS MEDIA,

SOCIAL CONTROL, AND SOCIAL CHANGE 9 (1998)

115

Id. (noting that social control is most effective when “external

control comes to be incorporated into the personality of the individual.”)

Underwater and Not Walking Away

26

month”116 and have lamented the erosion of “our common values”

by, for example, those who irresponsibly borrowed beyond their

means.117 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.”118

Paulson’s comment is mild, however, compared to the

media invective toward those who strategically walk from their

mortgages. Such individuals are portrayed as obscene,

119

offensive,120 and unethical,121 and likened to deadbeat dads who

walk out on their children,122 or those who would have “given up”

and just handed over Europe to the Nazis.123

There is similarly no shortage of moralizing about the

responsibilities of mortgagors. Typical media messages include:

"we need a culture of responsible consumers and homeowners;"

124

116

President Barack Obama, Foreclosure Speech: Housing Plan, (Feb.

18, 2009), available at

http://www.huffingtonpost.com/2009/02/18/obama-

foreclosure-speech_n_167889.html

117

Id.

118

Secretary Henry M. Paulson, Jr., U.S. Housing and Mortgage

Market Update before the National Association of Business Economists (Mar. 3,

2008), http://www.ustreas.gov/press/releases/hp856.htm.

119

Fox Business: Some Homeowners Who Can’t Pay Choosing to Just

Walk Away (Fox Business television broadcast Feb. 19, 2009), available at

http://www.foxbusiness.com/video/index.html?playerId=videolandingpage&stre

amingFormat=FLASH&referralObject=3644995&referralPlaylistId=1292d14d0

e3afdcf0b31500afefb92724c08f046 [hereinafter “Fox Business”]. (“Seems

obscene. Everyone else in the country is trying to pay their mortgages and

trying to get things done. They realize in many cases they are underwater that

their mortgage is worth more than their home. If you have obnoxious kids, walk

away from your kids. Seems weird. Doesn’t it?”)

120

Id. (“I know you are not looking at the ethics of this; you are a good

and savvy businessman. Do you find it even a tinge offensive that we are

moving away from personal responsibility? If we can’t hack it we bail out of

it.”)

121

The Mike Gallagher National Radio Show, Youwalkaway.com

(Townhall, May 1, 2009).

122

Fox Business, supra note 115.

123

Id. (“And you know when you enter into an agreement and

everyone just throws up the keys and says you know it’s really tough this month,

it’s gonna be tough next month, declining real estate values, we are just going to

quit. Can you imagine if we all did that going into World War II? The

Japanese just kicked our butts at Pearl Harbor, the odds are overwhelming, the

Germans have just taken over Europe, and we just quit. What would happen if

we all quit? Let’s just cease and desist.”)

124

Economy: Why Not Just Walk Away From A Home? (NPR radio

broadcast Feb. 13, 2008) available at

Underwater and Not Walking Away

27

“one should always honor financial obligations;125 “when you

enter into a contract that should mean something;”126 “there was a

time when people felt really bad about not paying back debt,” 127

and, “money is more than a matter of numbers. There are ethics

involved. Most people feel, or should feel, an obligation to pay

their debts.”128 Even sympathy for those who default because of

predatory lending is frequently lacking: “We’ve read too many sob

stories in the press about ‘predatory lending’ — a rare,

misunderstood, and vastly exaggerated phenomenon. It’s time for

the poster children for irresponsibility to get some face time.”129

Indeed, a homeowner contemplating a strategic default

would be hard pressed to avoid the message that doing so would

place them among the most despicable members of society. It is

thus not surprising that a large number of media stories about

individuals who walk on their mortgages indicate that these

individuals ask that their “last name not be used” to protect their

privacy.

130

Nobody wants to be indentified as a deadbeat – or, as

one commentator describes them, “a blight on our society."131

http://www.npr.org/templates/story/story.php?storyId=18958049

Such individuals seek to protect their privacy for good reason, as it

is not just the media and the government that acts as norm

enforcers, but also individuals – as can be seen in the frequent

railings on internet comment boards and blogs about strategic

defaulters. In one typical example, “Bob Green”, an individual

enraged by the story of “Raam” who posted his own story of why

he strategically defaulted on his mortgage, wrote: “Amazing.

Simply amazing. The types of speculators like ‘Raam’ and others

should be tied to a tree and left to rot. It’s these fine people who

are going to walk away and leave the societal, writ large, on the

[hereinafter

“NPR”].

125

Id.

126

Fox Business, supra note 119.

127

60 Minutes: The U.S. Mortgage Meltdown (CBS television

broadcast May 25, 2008), available at

http://www.cbsnews.com/video/watch/?id=4126094n&tag=related;photovideo.

128

Weston, supra note 2.

129

Steven Spruiell, Obama Pays Bail Money, NATIONAL REVIEW

ONLINE, June 12, 2008,

http://article.nationalreview.com/?q=OWJkNGE3ZjIyYTAzOTg0MWJlYmViM

2FlZGVjMjY4ZmY= [hereinafter “National Review”].

130

Weston, supra note 128, at 3.

131

Brian Eckhouse, Whether to Walk Away: Housing’s Moral

Minefield, LAS VEGAS SUN, Mar. 22, 2009,

http://www.lasvegassun.com/news/2009/mar/22/whether-walk-away-housings-

moral-minefield/

Underwater and Not Walking Away

28

hook for their problems. Good job Raam–way to take

responsibility.” 132

Moreover, a homeowner who turned to any number of

credit counseling agencies would also find little sympathy - and

much moralizing - should they announce their plan to walk on their

“affordable” mortgage. Gail Cunningham of the National

Foundation for Credit Counseling declared for example in an

interview on NPR: “Walking away from one's home should be the

absolute last resort. However desperate a situation might become

for a homeowner, that does not relieve us of our

responsibilities."

133

132

Posting of Bob Green to

Indeed, the uniform message of both

governmental and non-profit counseling agencies (which are

http://www.mint.com/blog/finance-

core/should-you-walk-away-from-your-home/. “Raam” tells his story as

follows:

I purchased my first rental property at the age of 21. Everyone

said I would make a killing and was really smart for investing

so young. I wish I had done more research and seen that we

were approaching an inevitable bubble. I bought my first

property (a 2-family) for $190k in 2003. Within a year it was

valued at double that. After refinancing and putting money

into the first property, I bought two more properties the

following two years. I had 12 tenants total (being a landlord is

no easy task!). The mortgage lenders were pushing ARM’s

like crazy… and they made sense to an investor like me. I

needed the lowest monthly payment so I could take the little

income left from the rent to put back into the properties. Plus,

I could always just refinance my 2-year fixed / 28 year

adjustable mortgage before the 2 years-fixed were up

(refinance to a conventional 30-year fixed)… right? Well,

taxes went way up. I had a few tenants that cost me over $15k

in lost rent (damn tenant-rights laws!), unexpected property

damage from frozen water pipes, a couple more bad tenants,

and while all this was happening the value of my house

secretly dropped below the amount I owed… oh sh*t. Then I

get a letter in the mail saying my monthly mortgage payments

are going to increase by more than $600 a month… but wait,

I’m already dishing out over $200 a month from my pocket to

pay for the properties (assuming all the units are fully rented)!

I can’t refinance because the value of the property is less than

what I owe. I can bust my ass for the next 5-10 years trying to

keep up with the payments or I can let everything fall down,

file for bankruptcy, and move on. I’m filing. And I’m damn

glad. $450k multi-family properties are now for sale at

$140k… less than I bought my first property in 2003. For me

it’s easy because they were investment properties, not houses

my family lived in (I’m single). I’m renting now and saving as

much money as I can, because when things start to turn around

I want to be ready, not buried under a million dollars in debt.

Posting of “Raam” to: http://www.mint.com/blog/finance-

core/should-you-walk-away-from-your-home/.

133

NPR, supra note 124.

Underwater and Not Walking Away

29

typically funded at least in significant part by the financial

industry) is that “walking away” is not a responsible choice134 and

should be avoided at all costs.135

What makes this moral suasion so effective is that major

socializing agents in the United States tend to speak with one

voice. Thus, when the government, or the credit industry, tells

individuals that they have a responsibility to pay their mortgage

even if they are seriously underwater, the message is seen as

“echoing a deep-seated American belief that one should always

honor financial obligations,”

136

– and not as an effort to fix the

primary burden of the housing meltdown on homeowners rather

than the financial industry or the government. More critically,

because the media and non-profit consumer counseling agencies

promote the same message, the government and the financial

industry need not bear the primary burden of moral suasion – nor is

the message ever identified with those political and economic

institutions that have a vested interest in promoting “homeowner

responsibility.” The message rings true to the ear and, as such,

most homeowners question neither the content of the message, nor

its source.137

Social control of would be defaulters is not limited to moral

suasion, however. Predominate messages regarding foreclosure

also frequently employ fear to persuade homeowners that strategic

default is a bad choice:

134

See, e.g., Fannie May, Foreclosure Prevention FAQs (answering the

question “is it best to walk away from my property if I can no longer make the

payments?” as follows: “Walking away from your property is not a good choice.

Continue to live in your house as long as you are trying to get help from your

mortgage company or through a housing counselor.”). Available at

http://www.fanniemae.com/homeowners/frequently-asked-questions.html (last

visited Oct. 9, 2009)

135

HUD, How to Avoid Foreclosure,

http://www.hud.gov/offices/adm/hudclips/forms/files/pa426h.pdf (last visited

Oct. 15, 2009) (stressing to homeowners that “you should avoid foreclosure if

possible” and “[d]on’t lose your home and damage your credit history); see also

Anaheim Housing Counseling Agency,

http://www.anaheimhousingcounselingagency.org/id21.html (last visited Oct. 9,

2009) (“Losing your home can be the worst and most devastating event to you

personally, and your credit history. This is a scenario that you don’t want to

occur if you can avoid it.”); see also, Foreclosure Avoidance Counseling,

http://www.hud.gov/offices/hsg/sfh/hcc/fc/ (last visited Oct. 9, 2009) (“HUD-

approved housing counseling agencies are available to provide you with the

information and assistance you need to avoid foreclosure.”).

136

NPR, supra note 124 (quoting, Gail Cunningham, spokeswoman for

the National Foundation for Credit Counseling).

137

See JOHN O'SHAUGHNESSY & NICHOLAS JACKSON O'SHAUGHNESSY,

THE MARKETING POWER OF EMOTION 61 (2003) (explaining that individuals

tend to uncritically endorse information that in line with their affective

predispositions).

Underwater and Not Walking Away

30

What is real--and what is very much downplayed by

these outfits [like YouWalkAway.com] --is how

completely a foreclosure wrecks your finances.

Near term, you might get slammed with a massive

tax bill, since forgiven debt can be subject to

income tax. Long term, car loans and--you guessed

it--home loans will be much harder to come by.

How's that for walking away? This is the American

Dream ended in disaster". 138

Indeed, almost every media story on those who “walk away

from their mortgages” condemns the behavior as immoral and

enlists some “expert” to explain that foreclosure is, despite any

claims to the contrary, a devastating event:139

138

Barbara Kiviat, Walking Away From Your Mortgage, TIME, June 19,

2008 available at

http://www.time.com/time/magazine/article/0,9171,1816472,00.html (quoting

Odette Williamson, a foreclosure lawyer at the National Consumer Law Center).

139

See, e.g., Kiviat, supra note 138:

The whole idea of walking away is troubling to consumer

advocates, who worry that these firms are whitewashing the

fact that foreclosure is a traumatic experience--both financially

and emotionally--that takes years to recover from.”

And, Nightline: The Big Cut (ABC Television broadcast Jan. 31,

2008), available at

http://abcnews.go.com/Video/playerIndex?id=4220208&affil=wxyz :

The thing is you have to take into consideration here

is that this is a real disaster for your credit, if you have a

foreclosure on your record, even default. But if you fall

behind on your mortgage, and don’t pay it, everyone you go to

borrow money from for the next 6-7 years is going to know

about this. When you try to find a job, when you try to rent an

apartment, this is going to be on your credit. It’s not like you

walk away free, you walk away with a huge black mark on

your credit rating.”

See also John A. Schoen, Why It’s a Bad Idea to Walk Away From the

Mortgage, MSNBC, March 16, 2009,

http://www.msnbc.msn.com/id/29669640// (editorializing that “[t]he most

important reason [why is a bad idea to walk away]: You signed a contract, took

the money and promised to pay the lender back. That’s what the law now

requires you to do”; and going on the explain that foreclosure will destroy your

credit”); Fox Business, supra note 119; Nightline, supra note 139; NPR, supra

note 124; Weston, supra note 2.; Santelli’s Tea Party (CNBC television

broadcast Feb. 19, 2009) available at,

http://www.cnbc.com/id/15840232?video=1039849853; Streitfeld, supra note

2; NATIONAL REVIEW, supra note 129; Can’t Pay, Won’t Pay, ECONOMIST, July

25, 2009,

Underwater and Not Walking Away

31

A single missed mortgage payment, says MSN

Money columnist and credit expert Liz Pulliam

Weston, knocks 100 points off your credit score.

Every missed payment thereafter compounds the

damage. A notice of default typically comes after

the third missed payment, delivering a knockout

blow to the homeowner's credit. … The direct effect

of any of these outcomes on credit scores is

dramatic, and it ripples through every corner of

borrowers' financial lives. The former homeowners

will be unable to get new credit at reasonable rates,

and issuers of their existing credit cards can raise

interest rates because they are considered greater

risks.140

Similar warnings of disaster pervade the information given

to homeowners by HUD-approved housing counseling agencies,

141

such as the following from the Anaheim Housing Counseling

Agency:

Losing your home can be the worst and most

devastating event to you personally, and your credit

history. This is a scenario that you don’t want to

occur if you can avoid it! Not only will you lose the

comfort of your home and your investment, but a

Foreclosure will stay pending on your credit history

for as long as 10 years. This will jeopardize your

ability to qualify for any future home loan

purchases, it may affect your ability to access loans

for car purchase and other needed purchases, and

http://www.economist.com/businessfinance/displayStory.cfm?story_id=139055

02.

140

HASSON, supra note 89.

141

Clearpoint Credit Counseling Solutions, Default and Foreclosure

Counseling,

http://www.bydesignsolutions.org/default_and_foreclosure_counseling.html

(last visited Oct. 10, 2009) (“For homeowners, the thought of losing your home

in a foreclosure is frightening. Your mortgage payment is usually your single

largest financial obligation.”); see also GreenPath Debt Solutions, Housing

Counseling, http://www.greenpath.com/how-we-can-help/housing-

counseling.htm (last visited Oct. 10, 2009) (“Greenpath’s housing counseling

services can help you preserve your most important asset, your home. After all,

tenants, homeowners and future home purchasers have a lot to lose if their

finances get out of control-and a lot to gain from housing counseling delivered

by an unbiased housing counselor.”).

Underwater and Not Walking Away

32

loan costs are likely to be higher both in fees and

interest paid.142

As discussed above, fear alone is a powerful motivator. But

guilt and fear in combination are even more potent.143

As explored above, however, there is in fact a huge

financial upside to strategic default for seriously underwater

homeowners – an upside that is routinely ignored by the media,

credit counseling agencies, and other political and economic

institutions in “informing” homeowners about the consequences of

This may

be because most individuals have a deep-seated, if ill-defined,

sense that if they do “bad things,” bad things will happen to them.

Whatever the psychological underpinnings, most people simply do

not believe they will escape punishment for their moral

transgressions. Guilt and fear of punishment go together. Thus,

the notion that one will suffer great consequences for walking

away from one’s financial obligations not only seems possible, but

feels quite right. It just can’t be that one can walk away from their

mortgage with no significant consequence. As such, people rarely

question apocalyptic descriptions of foreclosure’s consequences.

142

Anaheim Housing Counseling Agency,

http://www.anaheimhousingcounselingagency.org/id21.html (last visited Oct.

10, 2009); see also Fannie Mae, Foreclosure Prevention FAQs,

http://www.fanniemae.com/homeowners/frequently-asked-questions.html (last

visited Oct. 10, 2009) warning:

Foreclosures are extremely damaging to your credit and may

impact your credit rating for as long as seven years. A

foreclosure can make it difficult to get a loan for a future

home purchase, college expenses, or to get a major credit card.

If you are able to get credit, your interest rates will likely be

higher. For most people, it is well worth the time and effort to

avoid foreclosure.

See also, NPR, supra note 124 (quoting Ellen Schloemer, director of

research at the Center for Responsible Lending, for the proposition that “[i]t

takes a decade to recover from a foreclosure.”).

143

See, e.g., Dwight Merunka et. al., Modeling and Measuring the

Impact of Fear, Guilt and Shame Appeals on Persuasion for Health

Communication: a Study of Anti-Alcohol Messages (Working Paper,

2007)(finding that their study showed “that a threatening message implying fear,

guilt and shame together might well be the most persuasive.”), available at:

http://ssrn.com/abstract=963593. See also, Linda Brennan & Wayne Binney,

Fear, Guilt, and Shame Appeals in Social Marketing , J. BUS. RESEARCH (2009);

Lauren G. Block, Self-Referenced Fear and Guilt Appeals: The Moderating

Role of Self-Construal, 35 J. APPLIED SOC. PSYCH. 11 (2005); Francesco

Mancini & Amelia Gangemi, The Role of Responsibility and Fear of Guilt in

Hypothesis-Testing, 37 J. BEHAVIOR THERAPY & EXPERIMENTAL PSYCHIATRY

333 (2006); see also Guilt And Fear Motivate Better Than Hope, SCIENCE

DAILY, http://www.sciencedaily.com/releases/2006/02/060213091147.htm (last

visited Sept. 17, 2009).

Underwater and Not Walking Away

33

default. Moreover, the costs of default are not nearly as extreme as

these same institutions typically misrepresent them to be. In

reality: homeowners face no risk of a deficiency judgment in

many states144 or, regardless of the state, for FHA loans or loans

held by Fannie Mae or Freddie Mac;145 even in recourse states,

lenders are unlikely to pursue a deficiency judgment because it is

economically inefficient to do so;146 there is no tax liability on

“forgiven portions” of home mortgages under current federal tax

law in effect until 2012;147 defaulting on one’s mortgage does not

mean that one’s other credit lines will be revoked;148 and most

people can expect to recover from the negative impact of

foreclosure on their credit score within a two years149

Homeowners with high credit scores, however, may have

an especially hard time accepting the notion that a few years of

poor credit is no big deal. The hard to convince include the vast

majority of homeowners with prime loans, 94% of whom had

credit scores above 660 when they purchased their homes.

(and,

meanwhile, two years of poor credit need not seriously impact

one’s life).

150

Most

American homeowners see their good credit scores not only in

utilitarian terms (i.e. – as helpful in increasing one’s purchasing

power) but also as a “source of pride,” or a statement of their good

moral character.151

144

See Andra Ghent and Marianna Kudlyak, Recourse and Residential

Mortgage Default: Theory and Evidence from U.S. States, Federal Reserve Bank

of Richmond Working Paper No. 09-10, 5 (July 10, 2009), available at SSRN:

http://ssrn.com/abstract=1432437 (listing Alaska, Arizona, California, Iowa,

Minnesota, Montana, North Carolina, North Dakota, Washington and Wisconsin

as non-recourse states).

Indeed, the view that one’s credit score

reflects one’s character, or at least one’s sense of personal

responsibility and trustworthiness, is widespread in American

145

Id. at 3 (nothing deficiency judgments are barred for FHA loans)

and .

146

Ralph Roberts, Top Myths About Loan Modification, REALTY TIMES

(Jan. 6, 2009) http://realtytimes.com/rtpages/20090126_myths.htm.

147

Christie, supra note ___ at 2.

148

See Mortgage Forgiveness Debt Relief Act of 2007.

149

Christie, supra note __ at 1-2; Nina Silberstein, How Foreclosure

Affects Your Credit Score, AOL REAL ESTATE,

http://realestate.aol.com/article/credit/_a/how-foreclosure-affects-your-credit-

score/2009041001.(last visited Oct. 10, 2009).

150

ROBERT AVERY ET. AL., CREDIT RISK, CREDIT SCORING, AND THE

PERFORMANCE OF HOME MORTGAGES (1996), available at

http://www.federalreserve.gov/pubs/bulletin/1996/796lead.pdf (noting that

93.6% of conventional fix-rate mortgages have credit scores in the high range,

meaning above 660).

151

Rashmi Dyal-Chand, Human Worth as Collateral, 38 RUTGERS L.J.

793 (2007) (“A good credit score itself is now something about which to be

proud, and a bad credit score is something about which to be ashamed”).

Underwater and Not Walking Away

34

culture.152 This belief is not surprising given that the federal

statute that governs credit reporting, the Fair Credit Reporting Act

(“FCRA”), describes credit reporting as a “mechanism for

investigating and evaluating the credit worthiness, credit standing,

credit capacity, character, and general reputation of

consumers.”153

A bad credit score is – by design - meant to reflect not only

one’s poor creditworthiness, but also one’s poor moral character.

For individuals to lose their good credit is thus to lose not only

“their self-conceptions as people who keep their promises and pay

their debts on time,” but part of their “human worth” as well.

154

Even being “perceived as having bad credit” – such as having

one’s credit card turned down at a restaurant – is deeply

humiliating to most Americans.155 A bad credit score is nothing

less than a reputational scarlet letter that, because of the

“omnipresence of the credit reporting system,”156 follows

individuals wherever they go. As a result, Americans engage in a

great deal of “self-regulation in order to maintain good credit

scores.” The lending industry in turn “uses credit scores as a

threat” to constrain borrower behavior.157

This power to threaten borrowers means that though

mortgage agreements in non-recourse states contain an implied put

option, or contractual option to default and transfer ownership of

the home to the lender, the law plays a subordinate role in lender-

borrower relations. A borrower might in fact walk without legal

penalty, but the lender holds the borrower’s human worth as

collateral – and will likely trash it in retaliation for the borrower’s

exercise of their contractual right to default.

158

152

See id. at 793 (noting that “there appears to be a growing trend of

using credit reports as a proxy for screening and decision-making processes

outside the context of credit transactions, and in contexts where character was

once assessed in a more holistic manner. For instance, some relationship experts

now recommend using credit reports to evaluate the trustworthiness and

suitability of a potential romantic partner, while some businesses forego the

interview screening process entirely in favor of the information about an

individual that may be gleaned from a credit report”).

The credit

reporting system thus subordinates the law to social norms, and

makes it impossible for a strategic defaulter to avoid the

153

15 U.S.C. § 1681(a)(2) (2000)(emphasis added).

154

Id.

155

Id.

156

Id.

157

Id.

158

Id. (“In the consumer context, the connection between credit reports,

credit, and social status provides a means of eliminating a person's sense of

honor. Simply put, by reporting negative information to a credit bureau, a lender

can limit a borrower's acquisition of status-enhancing goods and services, and

more basically, lower her social standing”).

Underwater and Not Walking Away

35

reputational penalty of default, - even by packing up and moving

across the country. Indeed, for seven years, perfect strangers who

access the defaulter’s credit report will learn of the moral misdeed

and express their disapproval, if only by changing their tone of

voice in the way that individuals tend to do when addressing

someone of a lesser social status.159

In short, although the financial sting of a temporarily poor

credit score may be relatively easy to mitigate,

160

the damage to

one’s reputation and sense of self worth may be both more intense

and more enduring. This reality brings the question back full circle

to whether seriously underwater homeowners may be acting in

utility-maximizing ways by not walking away from their

mortgages. Indeed they may be - if emotional suffering is as a

mere transaction cost of default. But whether the behavior is

utility-maximizing misses the point. The point is that the credit

reporting system operates in conjunction with other economic,

political and social institutions as means of social control by

increasing the emotional cost of default. Moreover, the credit

reporting system operates largely outside legal process as a norm

enforcer,161

VI. The Asymmetry of Homeowner and Lender Norms

ensuring immediate reputational punishment for those

individuals who might be tempted to flout their “moral

commitment to pay” by exercising their legal right to default.

One obvious response to the above discussion is that

society benefits when people honor their financial obligations and

behave according to social and moral norms, rather than strictly

legal or market norms. This may be true if lenders behaved

according to the same social and moral norms. In the case of

lender-borrower behavior, however, there is a clear imbalance in

placing personal responsibility on the borrower to honor their

“promise to pay” in order to relieve the lender of their agreement

159

Seven years is the length of time that the fact of the foreclosure

remains on an individual’s credit report (though its effect on the actual score

will effectively disappear long before then).

160

For example, one might make any purchases for which one will

foreseeably need credit before default and use a debit card in place of a credit

card for purchases and rental car reservations after default.

161

The credit reporting system is governed by the Fair Credit Reporting

Act (“FCRA”) 15 U.S.C. § 1681. The “system” consists of a “consumer report,”

defined by the FCRA as “any written, oral, or other communication of any

information by a consumer reporting agency bearing on a consumer's credit

worthiness, credit standing, credit capacity, character, general reputation,

personal characteristics, or mode of living which is used or expected to be used

or collected in whole or in part for the purpose of serving as a factor in

establishing the consumer's eligibility for credit, insurance, or any other purpose

permitted by the FCRA. 15 U.S.C. § 1681a(d)(1)”

Underwater and Not Walking Away

36

to take back the home in lieu of payment. Given lenders generally

superior knowledge and understanding of both mortgage

instruments and valuation of real estate, it seems only fair to hold

them to the benefit of their bargain. At a basic level, sound

underwriting of mortgage loans requires lenders to ensure that a

loan is sufficiently collateralized in the event of default.162

As discussed above, a textbook premise of economics is

that a home’s value, even an owner occupied one, is “the current

value of the rent payments that could be earned from renting the

property at market prices.”

In

other words, in appraising a home the lender should ensure that the

loan amount, at the least, does not exceed the intrinsic market

value of the home.

163

As such, historical home prices

have hewed nationally to a price-to-annual-rent ratio of roughly

15-to-1.164 At the peak of the market, however, price-to-rent

ratios reached 38-to-1 in the most inflated markets, and the

national average reached 23-to-1.165

Moreover, since lenders generally arrange the appraisal

(which home buyers must pay for) and home buyers rely upon the

lender to ensure the home is worth the purchase price,

If personal responsibility is

the operative value, then lenders who ignored basic economic

principles (of which they should have been aware) should bear at

least equal responsibility to homeowners for issuing collateralized

loans that were far in excess of the intrinsic value of the home.

166

one might

argue that lender should bear much more than 50% responsibility

for the bad investment of the homeowner and lender. As Joseph

Stiglitz has explained, “for the most part, the lenders were, or

should have been, far more financially sophisticated than the

borrowers.”167 Lenders “should [thus] be made to bear the

consequences of their failures to assess risk.”168

162

See e.g., Financial Web, Mortgage Loan Underwriting,

http://www.finweb.com/mortgage-loan-education/mortgage-loan-

underwriting.html (last visited Oct. 10, 2009)

163

JIN RHO, ET. AL., supra note 25, at 3.

164

Id. at 4.

165

Shawn Tully, Real Estate: Buy, Sell, or Hold, FORTUNE, Nov. 7,

2007, available at

http://money.cnn.com/2007/11/06/real_estate/home_prices.fortune/index.htm

166

See James Hagerty, Reappraising Home Appraisers, WALL ST. J.,

Aug. 18, 2009 (noting that, “Appraisals are supposed to shield home buyers

from paying too much and lenders from overestimating the value of collateral. If

appraisals come in too high, buyers may overpay, making defaults more

likely.”).

167

Memorandum from Joseph E. Stiglitz to The Commission of

Experts of the President of the UN General Assembly on Reforms of the

International Monetary and Financial System, 1 , available at http://www.un-

gls.org/docs/ga/cfr/memo_foreclosures.pdf

168

Id.

Underwater and Not Walking Away

37

Indeed, lenders’ mortgage default risk models have long

shown that the loan-to-value ratio is a critical factor in default

risk.169 Lender underwriting practices thus traditionally required

that homeowners have sufficient equity (usually by making a

sufficient down payment) such that default would never be the “in

the money option.”170 Lenders relaxed this requirement, however,

as credit default models showed that few borrowers were

“ruthless,” meaning that few borrowers default as soon as the loan

value exceeds the market value of the home.171 Lenders thus

moved toward models that relied heavily on credit history as the

predictor of default risk. These models showed, for example, that

only 0.9% of borrowers with “high” credit scores and 4% of

borrowers with “medium” credit scores default on their

mortgages.172 This led lenders to conclude that default risk was

sufficiently low for borrowers with high and medium credit scores

that lenders could profitably offer a variety of alternative mortgage

products including zero-down loans, interest-only ARMS, and

negative amortization loans.173

In other words, lenders lost sight of the importance of

positive equity in lowering the risk of mortgage default, and failed

to ensure that homes were actually worth what they were being

purchased for.

174

This is not to say that lenders are solely

responsible for the housing run-up and bust, but that they do in fact

bear a substantial portion of the blame – and thus should thus bear

a substantial portion of the cost.175

169

Vandell, supra at 215 (noting the LTV’s dominant effect on

mortgage default was initially validated in the 1970 Herzog and Earley study).

One might argue, in fact, that

170

Id. at 212-213, 218.

171

Id. at 224 (finding that the first option-based models overestimated

the ruthless default of homeowners in comparison to that which was actually

observable in the market).

172

See AVERY ET. AL., supra note 145.

173

See Kerry D. Vandell, Handing Over the Keys, A Perspective on

Mortgage Default Research, 21 J. AM. REAL ESTATE & URBAN ECON. ASS’N

211 (1993)

174

See, e.g., CNBC.com, Boom, Bust and Blame - The Inside Story of

America's Economic Crisis, http://www.cnbc.com/id/32756455/ (last visited

Oct. 10, 2009) (noting that “[f]inancial institutions big and small got caught up

in the lending frenzy. Some were fly-by-night operations that made millions

through questionable loans. Others were well-known firms with strong

reputations, blinded by the promise of huge mortgage profits.”).

175

Of course, others share in the blame as well, including mortgage

brokers and appraisers who conspired to inflate home values, see e.g., LARRY

NEUMEISTER, 41 people in 4 states charged in mortgage fraud, Associated

Press Wire, October 15, 2009 (on file with author), and buyer’s real estate

agents, who pushed buyers to buy at inflated prices and failed to warn of an

impending bust that they knew, or should have known, was coming – or at the

very least failed to inform buyers once monthly trends began to show declining

prices. See Lew Sichelman, Legal battles over real estate transactions increase,

LOS ANGELES TIMES, October 4, 2009.

Underwater and Not Walking Away

38

the value of personal responsibility would require lenders to own

up to their share of the blame, and work with underwater

homeowners by voluntarily writing off some of the negative

equity.

But lenders, of course, do not operate according norms of

personal responsibility, and seek instead to maximize profit (or

minimize losses). Indeed, to the extent that the lender is a

corporation, the directors and executives of the corporation have a

legal duty to shareholders to maximize profit and/or minimize

losses. Appealing to this duty, it has been suggested that, given

the great cost to lenders of foreclosure, they have an economic

incentive to modify loans for homeowners in danger of default.176

This argument has flown in the face of the reality, however, that

lenders have been reluctant to modify loans, even for borrowers in

the pre-foreclosure process.177

Recent studies seeking to explain this apparently irrational

behavior have shown that lenders are simply operating to

maximize profit and minimize losses, just as they would be

expected to do.

178

First, lenders know that borrowers with high

credit scores are unlikely to default even at high levels of negative

equity.179 To modify loans for these homeowners would be to

throw money away – and to encourage more homeowners to ask

for modifications. Second, a significant number of homeowners

who temporarily default on their mortgages “self-cure” without

any help from their lender – though self cure rates have dropped

precipitously in the last two years.180

176

MORTGAGE BANKER’S ASSOCIATION, LENDER’S COST OF

FORECLOSURE, (2008), available at

http://www.nga.org/Files/pdf/0805FORECLOSUREMORTGAGE.PDF

(explaining that foreclosure is a prohibitively costly exercise for the mortgage

industry as it involves significant lost payments on principal, interest, as well as

necessitating legal, administrative, and property maintenance fees, all of which

are incurred by the lender).

Again, to modify the loans of

177

Manuel Adelino, Kristopher Gerardi, & Paul Willen, Why Don’t

Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures, and

Securitization (Federal Reserve Bank of Atlanta, Working Paper 2009-17, Aug.

2009), available at http://www.frbatlanta.org/invoke.cfm?objectid=149C4D27-

5056-9F12-12C089648203E1FD&method=display.

178

Id. See also Foote, et. al., supra note 14 at 1 (explain that “While

investors might be foreclosing when it would be socially efficient to modify,

there is little evidence to suggest they are acting against their own interests when

they do so.”)(emphasis in original)

179

Manuel Adelino, Kristopher Gerardi, & Paul Willen, Why Don’t

Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures, and

Securitization (Federal Reserve Bank of Atlanta, Working Paper 2009-17, Aug.

2009), available at http://www.frbatlanta.org/invoke.cfm?objectid=149C4D27-

5056-9F12-12C089648203E1FD&method=display

180

See Foote, et. al., supra note 14 at 2 (noting, “Investors also lose

money when they modify mortgages for borrowers who would have repaid

Underwater and Not Walking Away

39

individuals who would otherwise self cure would be to throw away

money. Third, homeowners with poor credit, or who end up in

arrears because of “triggering events” such as unemployment,

divorce, or other financially devastating circumstances are likely to

default on the modified loan as well.181

Given these economic incentives for the lender, a seriously

underwater homeowner with good credit and solid mortgage

payment history who responsibly calls his lender to work out a

loan modification is likely to be told by his lender that it will not

discuss a loan modification until the homeowner is 30 days or

more delinquent on his mortgage payment.

To modify loans for these

individuals is to waste time and risk housing prices falling further

before the lender eventually has to foreclosure and sell the property

anyway.

182

The lender is

making a bet (and a good one) that the homeowner values his

credit score too much to miss a payment and will just give up the

idea of a loan modification. However, if the homeowner does

what the lender suggests, misses a payment, and calls back to

discuss a loan modification in 30 days, the homeowner is likely to

be told to call back when he is 90 days delinquent.183 In the

meantime, the lender will send the borrower a series of strongly-

worded notices reminding him of his moral obligation to pay and

threatening legal action, including foreclosure and a deficiency

judgment, if the homeowner does not bring his mortgage payments

current. The lender is again making a bet (and again a good one)

that the homeowner will be shamed or frightened into paying their

mortgage. If the homeowner calls the lender’s bluff and calls back

when he is 90 days delinquent, there is a good possibility that he

will be told that his credit score is now so low that he does not

qualify for a loan modification.184

anyway, especially if modifications are done en masse, as proponents insist they

should be.”)

The homeowner must then

decide whether to bring the loan current or face foreclosure. If the

homeowner somehow makes clear to the lender that he has chosen

181

See Id. (“Moreover, the calculation [that lenders are acting against

their own interest] ignores the possibility that borrowers with modified loans

will default again later, usually for the same reason they defaulted in the first

place.”); See also Manuel Adelino, Kristopher Gerardi, & Paul Willen, Why

Don’t Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures, and

Securitization (Federal Reserve Bank of Atlanta, Working Paper 2009-17, Aug.

2009)

182

See Edmund L. Andrews, My Personal Credit Crisis, N.Y. TIMES,

May 14, 2009, available at

http://www.nytimes.com/2009/05/17/magazine/17foreclosure-

t.html?pagewanted=all (describing the author’s efforts to renegotiate his

mortgage with his lender)

183

Id.

184

Id.

Underwater and Not Walking Away

40

foreclosure, the lender may finally be willing to negotiate a loan

modification, a short-sale or a deed-in-lieu of foreclosure – all of

which still leave the homeowner’s credit in tatters (at least

temporary).

Most lenders will, in other words, take full advantage of the

asymmetry of norms between lender and homeowner and will use

the threat of damaging the borrower’s credit score to bring the

homeowner into compliance. Additionally, many lenders will only

bargain when the threat of damaging the homeowner’s credit has

lost its force and it becomes clear to the lender that foreclosure is

imminent absent some accommodation. On a fundamental level,

the asymmetry of moral norms for borrowers and market norms for

lenders gives lenders an unfair advantage in negotiations related to

the enforcement of contractual rights and obligations, including the

borrower’s right to exercise the put option. This imbalance is

exaggerated by the credit reporting system, which gives lenders the

power to threaten borrowers’ human worth and social status by

damaging their credit scores – scores that serve as much as grades

for moral character as they do for creditworthiness.185

VII. Leveling the Playing Field

The result

is a predictable imbalance in which individual homeowners have

born a huge and disproportionate burden of the housing collapse.

While the federal government has given billions to bailout

financial institutions, the primary assistance that it has offered to

underwater homeowners has been allowing them to refinance up to

125% of their home’s current value at “today’s lower interest

rates”186 – if they are current on their mortgage and their original

loan was insured by Freddie Mac or Fannie Mae.187 Additionally,

for homeowners “at risk of imminent default,” the Treasury

Department has encouraged lenders to voluntarily modify loans so

that borrower payments do not exceed 31% of their total monthly

income.188 In order to incentivize such loan modifications, the

Treasury Department has offered lenders $1,000 for each eligible

mortgage they modify, plus $1,000 per year for three years as long

as the borrower remains in the program.189

185

See Rashmi Dyal-Chand, Human Worth as Collateral, 38 RUTGERS

L.J. 793 (2007)

Additionally, once the

186

Press Release, HUD, Sec’y Donovan Announces Expanded

Eligibility For Making Home Affordable Refinancing (Jul.y1, 2009), available

at http://www.hud.gov/news/release.cfm?content=pr09-104.cfm.

187

Id.

188

See Press Release, Dep’t Treasury, Making Home Affordable:

Updated Detailed Program Description (Mar. 4, 2009) available at

http://www.treas.gov/press/releases/reports/housing_fact_sheet.pdf.

189

See id.

Underwater and Not Walking Away

41

lender has absorbed the cost of reducing the monthly debt-to-

income ratio to 38%, the Treasury Department will share the cost,

dollar-for-dollar, of reducing the ratio further to 31%.190

Government policy makers have premised this approach on

two central tenants: (1) that the key to preventing foreclosures is to

ensure that mortgage payments are affordable; and (2) that the

severity of the foreclosure crisis in the United States is due in large

part to lenders unwillingness to renegotiate mortgages to make

them more affordable.

191

Policy makers have grounded this single-

minded focus on affordability upon studies from earlier, less

severe, housing busts that showed that borrowers with affordable

mortgages rarely default.192

There are several problems, however, with focusing on

affordability alone as the key to averting the worsening of the

foreclosure crisis. First, government programs have defined

“unaffordable” as a total monthly payment exceeding 30% of one’s

gross monthly income.

193

This arbitrary cut off does not account

for the reality that even if one’s payment doesn’t exceed 30% of

gross monthly income, paying - for example - $3000 a month for a

home that could be purchased or rented today for around $1000 a

month is financially unwise. Or as “an economist might argue ...

an unaffordable mortgage is one that is really too expensive, in the

sense that the benefits that come with making payments on the

mortgage no longer outweigh the opportunity costs of doing so.”194

Conversely, paying 30% of gross monthly income to a

mortgage will leave many middle-to-low-income individuals with

little to spare – especially to the extent that individuals have other

significant financial obligations such as child care or medical bills.

Indeed, leaving aside monthly budget concerns, 30% (or even

20%) of one’s income is a significant percentage if the payment is

essentially being thrown away into a large negative equity hole out

To account for this fact, “affordable” might instead be defined not

only according to one’s grossly income, but also in relation to the

fair rental value of one’s home. A home that cost three times more

to own than it would to rent is by definition unaffordable. On the

other hand, a home that cost less to own than it would to rent might

be not too expensive even if the payment exceeds 30% of one’s

gross monthly income, as long as one could make the payment

with room to spare.

190

Id.

191

Adelino, Gerardi, & Willen, supra note 165.

192

Guiso et al., supra note 11, at 21

193

See HUD, Affordable Housing,

http://www.hud.gov/offices/cpd/affordablehousing/index.cfm (last visited Oct.

6, 2009) (stating, “The generally accepted definition of affordability is for a

household to pay no more than 30 percent of its annual income on housing.”).

194

See Foote, et. al, supra note 70 at 4.

Underwater and Not Walking Away

42

from which one is not likely to dig. Once a home has become an

albatross instead of an investment, struggling to pay a mortgage

makes no financial sense, almost regardless of one’s monthly

payment. For many homeowners, technical affordability is not the

lone consideration. Relative affordability and negative equity both

matter as well – and once negative equity is severe enough, it may

overwhelm other considerations.

Recognizing this reality, number of proposals have been

put forth to address the relative affordability and/or negative equity

problem. Joseph Stiglitz has suggested, for example, that the

government should itself become a lender and issue mortgages at

low interest rates, which would help address the relative

affordability issue and partially compensate for negative equity.195

Others have suggested that the government use stimulus funds to

buy down underwater mortgages196 or assist homeowners through

grants that would cover a portion of their payments.197

In contrast to a government bailout of underwater

homeowners, others have proposed measures that would force

lenders to write off some of the principal of underwater mortgages,

Each of

these proposals would bring some balance to the government’s

current approach to the mortgage crisis by providing direct

assistance to homeowners as opposed to injecting money into the

banking system in hopes that some of the benefit will trickle down

in the form of greater credit availability. Equally as important,

they would circumvent the problems created by norm asymmetry

between borrowers and lenders because borrowers could go to the

government for help regardless of their lender’s willingness to

renegotiate.

195

Stiglitz has argued that such a program would allow the government

to earn a return on these mortgages and incentivize the mortgage industry to

compete by restructuring loan terms. Memorandum from Joseph E. Stiglitz to

The Commission of Experts of the President of the UN General Assembly on

Reforms of the International Monetary and Financial System, 2-3 , available at

http://www.un-gls.org/docs/ga/cfr/memo_foreclosures.pdf. However, in order

to adequately compensate for negative equity, especially for homeowners who

are hundreds of thousands of dollars underwater, interest rates would have to be

truly low - as in somewhere around 2-3%.

196

Rebel A. Cole, The Housing-Asset Relief Program: A Plan for

Stabilizing the Housing and Securities Markets (April 22, 2009). Available at

SSRN: http://ssrn.com/abstract=1338883 (proposing that “$300 billion in TARP

or stimulus funds” be “used to write down the principals on underwater

mortgages.”)

197

Christopher L. Foote, et., al., A Proposal to Help Distressed

Homeowners: A Government Payment-Sharing Plan, FRB of Boston Public

Policy Brief No. 09-1 (July 9, 2009), available at SSRN:

http://ssrn.com/abstract=1432514 (proposing a “government payment-sharing

arrangement” whereby the government would pay part of the homeowner's

existing mortgage, providing a “significant reduction in the homeowner's

monthly mortgage payment.”)

Underwater and Not Walking Away

43

without the government picking up the tab. For example, Adam

Levitin has proposed allowing bankruptcy judges to write down

mortgages on primary residences, which is prohibited under

current bankruptcy law.198

Partially in response to this concern, Eric Posner and Luigi

Zingales have suggested changing federal bankruptcy law to allow

“prepackaged,” or streamlined, mortgage cram-downs under

Chapter 13 of the Bankruptcy Code.

This proposal too is a step in the right

direction in that it would help compensate for the problems of

norm asymmetry by eliminating the need for borrowers to

negotiate with lenders. However, Levitin’s proposal would help

only underwater homeowners who qualified for bankruptcy and

could show that they could not “afford” their mortgage payments.

It would thus fail to assist many responsible underwater

homeowners who did not reach beyond their means, but simply

purchased at the wrong time.

199

Under Posner and

Zingales’ intriguing proposal, any homeowner who lives in a ZIP

code where the median home price has dropped by more than 20

percent from its peak would have the right to submit a “Chapter 13

prepack.”200 This prepack “would simply contain a new mortgage

amount that is equal to the old mortgage amount discounted by the

percentage decline of the median house price for the ZIP code.

Monthly payments would decline by the same percentage; the term

of the mortgage would not be changed.”201 The creditor would

not have the right to oppose the prepack, but would be entitled to a

percentage of the home’s appreciate upon sale equal to the

percentage reduction in the principal pursuant to the prepack.202

Like the Levitin proposal, the prepackage bankruptcy

would be a positive step in circumventing the barriers to

renegotiation caused by norm asymmetry. The prepack also has

several advantages to the Levitin proposal, including that it would

impose less of a burden on the courts because the prepackage

bankruptcy would be “automated, requiring only a rubber stamp by

a bankruptcy judge.”

203

198

See Adam Levitin, Resolving the Foreclosure Crisis: Modification

of Mortgages in Bankruptcy, (April 24, 2009) Available at SSRN:

Nevertheless, the prepack proposal has

http://ssrn.com/abstract=1071931 (arguing for modification of home-mortgage

debt in bankruptcy proceedings); See also Eric A. Posner & Luigi Zingales ,

The Housing Crisis and Bankruptcy Reform: The Prepackaged Chapter 13

Approach 21 (School of Business Research Paper No. 09-11; U of Chicago Law

& Economics, Olin Working Paper No. 459, February 25, 2009), available at

http://ssrn.com/abstract=1349364. (discussing similar proposal from Senator

Durbin).

199

Posner & Zingales, supra note , at .

200

Id.

201

Id.

202

Id.

203

Id.

Underwater and Not Walking Away

44

significant drawbacks as well, including that it would intrude ex

post into the contractual relationship of private parties and would

create additional administrative burdens for already over-burdened

bankruptcy courts.204 It is also a blunt instrument in that it

arbitrarily limits cramdowns to ZIP codes where prices have

declined 20% and does not account for the often great variation of

depreciation within a single ZIP code.205

While the Posner and Zingales’ and the Levitin proposals

are worth considering, understanding norm asymmetry suggests

other possibilities. One solution that naturally follows, for

example, would be for the government – or some consumer

advocacy group - to begin a public education campaign

encouraging underwater homeowners to walk if their lender is

unwilling to negotiate. Whether or not such an approach would be

effective, it would likely be so distasteful to most policy makers,

and many readers of this article, that this idea will not be pursued

further here.

At a minimum, however, federally-approved and supported

housing and credit counseling agencies should cease in sending the

fear-laden message that foreclosure should be avoided at all cost.

They should also provide accurate information – including that

defaulting homeowners face no risk of a deficiency judgment in

many states206 or, regardless of the state, for FHA loans or loans

held by Fannie Mae or Freddie Mac;207 there is currently no tax

liability on “forgiven portions” of home mortgages;208 and most

people can expect to recover from the negative impact of

foreclosure on their credit score within a two years.209

204

Id.

In other

words, the government should, at least, stop perpetuating scary

myths about the consequences of foreclosure and could tone down

its moral rhetoric.

205

The plan would thus be over-inclusive and under-inclusive, allowing

some owners a write-down even when their particular neighborhood had not

experienced declines exceeding the magical 20% cut off, but denying relief to

others who neighborhoods had experienced steep declines, but whose overall

ZIP code had fared better than a 20% decline.

206

See Andra Ghent and Marianna Kudlyak, Recourse and Residential

Mortgage Default: Theory and Evidence from U.S. States, Federal Reserve Bank

of Richmond Working Paper No. 09-10, 5 (July 10, 2009), available at SSRN:

http://ssrn.com/abstract=1432437 (listing Alaska, Arizona, California, Iowa,

Minnesota, Montana, North Carolina, North Dakota, Washington and Wisconsin

as non-recourse states).

207

Id. at 3 (nothing deficiency judgments are barred for FHA loans)

and .

208

Christie, supra note ___ at 2.

209

Christie, supra note __ at 1-2; Nina Silberstein, How Foreclosure

Affects Your Credit Score, AOL REAL ESTATE,

http://realestate.aol.com/article/credit/_a/how-foreclosure-affects-your-credit-

score/2009041001.(last visited Oct. 10, 2009).

Underwater and Not Walking Away

45

Given the credit rating system’s role in enforcing norm

asymmetry, however, additional measures might be necessary to

level the playing field between borrowers and lenders and

empower homeowners to renegotiate underwater mortgages. One

such solution, for example, would be to amend the Fair Credit

Reporting Act to prevent lenders from reporting mortgage defaults

and foreclosures to credit rating agencies.210

The suggestion that Congress should amend the Fair Credit

Reporting Act to prevent lenders from reporting mortgage defaults

is premised upon the underlying mortgage contract, in which

lenders agree to hold the house alone as collateral. In the case of

underwater mortgages, however, the portion of the mortgage above

the home’s present value essentially becomes unsecured. Lenders

compensate for this by holding the borrowers’ credit score, and

thus their human worth, as collateral – thereby altering the

underlining agreement that the home serves as the sole collateral.

As a consequence, lenders are often able to reap the benefit, but

escape the costs, of their bargain.

To be clear, however,

this proposal is not presented here as the only possible solution to

the exclusion of all others. Rather it is presented as a jumping off

point for further discussion as to how norm asymmetry can be

addressed and lenders encouraged to voluntary renegotiate

mortgages. At the very least, it is a useful thought experiment. At

the best, it may in fact be the key to eliminating norm asymmetry

between lenders and borrowers, forcing a more equitable division

of the housing crisis’s financial burden, and preventing the

foreclosure crisis from spreading to prime loans.

Preventing lenders from reporting mortgage defaults to

credit rating agencies would, as a practical matter, eliminate

lenders’ ability to hold borrowers’ human worth as collateral.

Such a change would also serve as an important signal from the

government – sending the message that a borrower who exercises a

contractual right to default should not be viewed as immoral or

irresponsible. It would thus help considerably in leveling the

playing field between lenders and borrowers. With the threat of

damage to the borrower’s credit score removed, the borrower could

more credibly threaten to walk absent a principal reduction. It

bears emphasizing, however, that the borrower would be unlikely

to bargain “ruthlessly” because, even without the credit reputation

210

Ideally, this change would be coupled with an extension beyond

2012 of the federal tax waiver on “forgiven” portions of one’s mortgage and a

national anti-deficiency statute barring lenders from pursuing homeowners for a

mortgage’s unsatisfied portion upon foreclosure. Though not without

controversy, extending the tax waiver and passing an anti-deficiency statute

address the underlying economic costs of default to the borrower and, other

consequences aside, it should therefore be self-explanatory why they would help

improve borrowers bargaining position.

Underwater and Not Walking Away

46

hit, there are significant transaction costs to moving and finding a

new home.211 Indeed, because of these costs, and attachment to

home,212 few homeowners would walk at less than 10% negative

equity.213

Thus, if a mortgage were underwater, for example, by 20%,

the lender and homeowner might agree to share equally in

absorbing the loss - or a homeowner might agree to absorb all of

the negative equity in exchange for a reduction in the interest rate.

The parties might also agree to condition any reduction in principal

on the lender sharing in future appreciation – in effect converting

the mortgage into a shared equity loan. In other words, the lender

and homeowner would be free to negotiate a mutually beneficial

arrangement to continue the mortgagor-mortgagee relationship, or

they could settle for the benefit of their original bargain and the

mortgagor could have the house.

Additionally, this approach would have significant

advantages over Posner and Zingales’ proposal for forced

cramdowns. First, it would allow the parties to come to their own

mutually agreeable solution to the negative equity problem,

without the government intruding into a private contractual

relationship and rewriting the contract itself. Second, it allows for

nuanced, borrower-specific solutions, rather across the board

treatment for whole ZIP codes, or arbitrary cut-offs based upon a

set percentage of the borrower’s gross monthly income. Third, it

would not require the government to create a new bureaucratic

structure or expend any taxpayer money - nor would it impose new

regulations on lenders. The proposal simply identifies a distortion

in the market created by norm asymmetry and eliminates that

distortion. Indeed, the proposal to eliminate the credit threat is, at

heart, a market-based solution. It should thus be preferable to a

government bailout of homeowners or a government take-over of

the lending industry.214

211

See ROBERT AVERY ET. AL., supra note 145.

By the same token, it should be attractive

212

Indeed, lenders benefit not only from negative emotions such as

guilt and fear, but also positive attachment to the idea of homeownership. This

emotional attachment to homeownership is also socially cultivated and been

internalized by most Americans, who generally see homeownership as both a

good investment and an integral part of the American dream -and thus may cling

to their homes when they could walk away, rent something nicer, and put the

money they save into an investment with better returns.

213

Guiso et al., supra note 11, at 21.

214

The proposal is, of course, not likely to satisfy those that believe

homeowners have a moral obligation to pay their mortgage regardless of

whether it would be more efficient to breach. Nor, it goes without saying, is the

proposal going to be welcomed by the lending industry.

Underwater and Not Walking Away

47

to consumer advocates in that it protects the credit of underwater

homeowners and gives them more leverage to negotiate. 215

Nevertheless, some might still object that eliminating the

credit threat would encourage default among underwater

homeowners.

216

215

There is already a large and growing industry devoted to helping

underwater homeowners negotiate write-downs with lenders. As evidence of

the size of this industry, there have been “massive numbers of complaints” in

California against lawyers who have taken fees to renegotiate mortgages and

have failed to deliver. Jim Wasserman, Loan modification firms banned from

demanding upfront fees, SACRAMENTO BEE, 6B, Oct. 13, 2009. As a result,

lawmakers in California passed legislation to bar up-front fees for mortgage

renegotiation services. See Advanced Fees For Loan Modification are now

Illegal in California, California Department of Real Estate. Available at

http://www.dre.ca.gov/pdf_docs/FraudWarningsCaDRE03_2009.pdf It thus

seems fair to say that eliminating the credit threat would – at a minimum - help

the thousands of people who are already trying to negotiate with their lenders,

but find they have little leverage unless they are willing signal their willingness

to walk by missing payments and sacrificing their credit scores.

But that is, in part, the point: in an environment

216

Rather than objecting that eliminating the credit threat would

encourage default among underwater homeowners, others are likely to argue the

opposite: namely, that eliminating the credit threat would do nothing to alter

homeowner behavior. This objection would be grounded upon surveys that have

shown that many people don’t understand what a credit score is, much less care

about their own. See, Oren Bar-Gill and Elizabeth Warren, Making Credit

Safer, 157 U. PA. L. REV. 1 (2008)(arguing that “survey evidence also suggests

that “[m]ost consumers do not understand what credit scores measure, what

good and bad scores are, and how scores can be improved.”) However, credit

knowledge surveys have not isolated people with high credit scores to see what

they know or how they feel about credit scores (and, as discussed above, 94% of

people with prime loans have high credit scores). This subset of the population

with high credit scores likely cares more and know more about credit scores

than the general population. Moreover, despite headlines to the contrary, credit

knowledge surveys have actually shown that a very significant portion of the

population does in fact understand the importance of good credit, care about

their credit scores, and understand the basics of credit reporting. See e.g., Press

Release, Consumer Fed'n of Am. & Providian, Most Consumers Do Not

Understand Credit Scores According to a New Comprehensive Survey 1 (2004),

available at http://www.consumerfed.org/pdfs/092104creditscores.pdf

(concluding that “most consumers don’t understand credit scores” despite

finding that “most customers correctly understand that lenders use credit

scores,” 34% correctly understand that credit scores measure credit risk, 35%

understand that credit scores are unrelated to income, and 60% correctly

understand how to improve their credit score); Poll: Consumers Don't

Understand Credit Reporting, Favor Reforms, Ins. J., Aug. 11, 2003,

http://www.insurancejournal.com/news/national/2003/08/11/31410.htm (finding

that consumers don’t understand many specifics of credit reporting, but finding

that 97% understand that they have the right to see their credit report, 81% know

that consumers who fail to qualify for a loan have the right to a free credit

report, 46% understand that in most states they must pay a fee to obtain their

credit report, 45% understand that their credit score may be lowered if they use

all of the credit available on their credit card, and that 73% understand that their

credit score measures their credit-worthiness.); Survey: 27% of Consumers Do

Not Read Credit Reports, Credit & Collections World, Oct. 5, 2006,

Underwater and Not Walking Away

48

where there was less stigma attached to default and where

homeowners could more credibly threaten to walk away, lenders

would be more willing to negotiate with underwater homeowners.

The end result would paradoxically be fewer defaults - as

homeowners would not feel compelled – or be told – to default

before the lender would negotiate. Moreover, even if there were

more initial defaults, fewer of these defaults would end in

foreclosures - as a missed payment would signal the homeowner’s

seriousness to the lender and bring the lender more quickly to the

table. This would stand in sharp contrast to the current

environment where lenders often have an economic incentive not

to work with borrowers, on the theory that the vast majority of

those who threaten to default will not follow through and that

modifying mortgages of underwater homeowners will simply

encourage more defaults.217

The proposal’s value in forcing lenders to negotiate should

not be underestimated. Indeed, “every major policy action to date

has involved encouraging lenders, in one way or another, to

renegotiate loan terms in order to reduce borrower debt loads.”

This includes, of course, the Making Home Affordable program,

which tries to encourage renegotiation by offering modest financial

incentives to lenders. As the paucity of loan modifications under

http://creditandcollectionsworld.com/article.html?id=20061016NIJPR6OI

(finding that 73% of individuals have at some point checked their credit score);

Scores & Jobs, CardFlash, Sept. 14, 2007, http://

www.cardweb.com/cardflash/2007/09/14/scores-jobs (finding hat 60% of

individuals had checked their credit score and that a full 22% of respondents

check their credit score every year); U.S. Gov't Accountability Office, Credit

Reporting Literacy: Consumers Understood the Basics but Could Benefit from

Targeted Educational Efforts 10-11 (2005), available at http://

www.gao.gov/new.items/d05223.pdf (reporting that 70% of respondents

correctly defined a credit score). Individuals who care about and understand

their credit score likely constitute a much more significant portion of people

with prime loans (with is only subset of individuals about which this proposal is

concerned) than the general population. Moreover, one does not really need to

understand much about one’s credit score to not want to mess it up – and even

the most ignorant homeowner likely knows a foreclosure will hurt his credit. It

thus makes sense that removing the credit threat would alter the behavior of at

least a significant minority of underwater homeowners.

217

Even a relatively modest increase in the number of credible threats

of default could alter the economic calculation for lenders that causes them not

to renegotiate. Such would be the likely outcome of removing the credit threat -

as the signaling function of a late payment would be less costly to borrowers,

meaning many more people would default if necessary in order to bring lenders

to the table. But, it should be emphasized that the increase in defaults would

likely be temporary - as lenders would soon comprehend that it would be less

costly to negotiate with borrowers who threaten default before they actually stop

making payment.

Underwater and Not Walking Away

49

this program attests,218 however, offering lenders a few thousand

dollars to modify delinquent loans does not alter the underlying

economic incentives or the lender-borrower dynamic that drives

lenders to prefer foreclosure to renegotiation.219 Voluntary

renegotiation of home mortgages has remained the elusive “public

policy holy grail.”220

Despite these benefits, one might still object to the proposal

on the theory that the lender’s ability to collateralize borrowers’

credit scores reduces risk to the lender, thereby allowing them to

offer lower interest rates.

This failure to effectively encourage

voluntary renegotiation has stemmed – at least in part - from policy

makers’ failure to appreciate the role of norm asymmetry in

lenders’ unwillingness to negotiate with borrowers (at least not

until borrowers have shown their willingness to sacrifice their

credit scores). Eliminating the credit threat may thus, in fact, be

part of the key to unlocking the holy grail of voluntary

renegotiation.

221

Thus, the argument would go,

eliminating the credit threat would increase borrowers’ lending

costs and restrict credit. At the outset, it bears noting that this is

the typical argument against most consumer protections – and that

similar arguments can be expected against any proposal that would

effectively shift some of the burden of underwater mortgages off

homeowners and onto lenders.222

218

Though the Treasury Department predicted that these programs

would offer assistance to 7 to 9 million homeowners, only 360,165 loan

modifications had taken place under the program as of August 31, 2009.

Financial Stability, Making Home Affordable Program: Servicer Performance

Report through August 2009, http://www.financialstability.gov/docs/MHA-

Public_090909.pdf (last visited Oct. 10, 2009).

Indeed, the same arguments

about increased interest rates and restricted credit have been made

219

Id. (noting, “No matter which definition of renegotiation we use,

one message is quite clear: lenders rarely renegotiate. Fewer than 3 percent of

the seriously delinquent borrowers in our sample received a concessionary

modification in the year following the first serious delinquency.”)

220

Manuel Adelino, Kristopher Gerardi, & Paul Willen, supra note 165

(noting “there is a consensus among many observers that concessionary

modifications are the most, or possibly the only, effective way of preventing

foreclosures.”)

221

Relatedly, others might argue that barring the reporting of mortgage

defaults would reduce the utility of the credit reporting system in providing

information about the reliability of potential borrowers. This is true only if one

assumes that the same information about borrowers is relevant for secured

verses unsecured debt. However, it would seem that secured debt, such as home

mortgages, should operate in a different sphere than unsecured debt – where in

fact the only collateral the lender has is the borrowers’ credit score. See Avery,

supra note [x] (discussing separate risk assessment model that already exists for

home mortgages)

222

See Posner & Zingales, supra note [x], at [x]. (noting that “[t]he

financial industry opposes any loan modification because it will increase the

future cost of credit and reduce its availability.”).

Underwater and Not Walking Away

50

in opposing mortgage cramdowns – though recent empirical work

by Adam Levitin and Joshua Goodman has suggested that

permitting bankruptcy modification of mortgages would have little

to no impact on mortgage markets. 223

Moreover, any possible costs of eliminating the credit

threat should be weighed against the potentially enormous benefit

of empowering homeowners to more successfully negotiate away

their negative equity. First, numerous studies have shown that

negative home equity reduces consumer spending: the higher the

incidence of negative equity in the housing market, the weaker

aggregate demand in the overall economy.

Predictions of high interest

rates and restricted credit should thus be approached with a healthy

bit of skepticism.

224

Second, negative

home equity is associated with drastically reduced household

mobility,225

223

Adam Levitin and Joshua Goodman, The Effect of Bankruptcy Strip-

Down on Mortgage Markets, Georgetown Law and Economics Research Paper

No. 1087816 (February 6, 2008), available at SSRN:

which has a range of negative macroeconomic effects,

http://ssrn.com/abstract=1087816 (arguing that current and historical data

suggests that permitting bankruptcy modification of mortgages would have no or

little impact on mortgage markets, including mortgage interest rates); and Adam

Levitin, Resolving the Foreclosure Crisis: Modification of Mortgages in

Bankruptcy, (April 24, 2009) Available at

SSRN:http://ssrn.com/abstract=1071931 (arguing that “permitting modification

would have little or no impact on mortgage credit cost or availability.”); See

also Adam Levitin,, A Critique of the American Bankers Association's Study on

Credit Card Regulation, Georgetown Law and Economics Research Paper No.

1029191; Georgetown Public Law Research Paper No. 1029191 (August 18,

2008) Available at SSRN: http://ssrn.com/abstract=1029191 (disputing

contention by American Bankers Association that credit card regulation

increases interest rates).

224

See Tomas Hellebrandt, et. al., The Economics and Estimation of

Negative Equity, BANK OF ENGLAND QUARTERLY BULLETIN 2009 Q2 (June 12,

2009)(arguing that “A rising incidence of negative equity is often associated

with weak aggregate demand.”); M. Corder and N. Roberts (2008),

‘Understanding dwellings investment’, 48 BANK OF ENGLAND QUARTERLY

BULLETIN 393 (indicating that negative equity reduces the incentive for

homebuilders and homeowners to invest in housing) A. Benito, et. al., House

prices and durables spending, BANK OF ENGLAND QUARTERLY BULLETIN 142–

54 (Summer 2006)(showing that negative equity negatively affects aggregate

consumer spending); Benito, A and Mumtaz, H (2006), Consumption excess

sensitivity, liquidity constraints and the collateral role of housing, Bank of

England Working Paper No. 306. (2008) (negative equity raises the probability

of a household being credit constrained and thus unable to purchase); R. Disney,

et. al., House price shocks, negative equity and household consumption in the

United Kingdom, JOURNAL OF EUROPEAN ECONOMIC ASSOCIATION

(forthcoming 2008)(negative equity leads to greater savings and lower

spending.); and Drowning in Debt, supra note 6 at 16 (noting that negative

equity suppresses middle class consumption)

225

See Tomas Hellebrandt, et. al., The Economics and Estimation of

Negative Equity, BANK OF ENGLAND QUARTERLY BULLETIN 2009 Q2 (June 12,

2009) (indicating that “Negative equity can affect household mobility by

Underwater and Not Walking Away

51

including increased structural unemployment, reduced

productivity, and limited the supply capacity.226

Moreover, barring the reporting of mortgage defaults could

have positive effects on future lender behavior. This is because in

the case of a home mortgage, the lender has the ability to ensure

that the collateral is sufficient to create the proper economic

incentives for borrowers not to default. In other words, they need

not rely upon credit scores to control their risk, but can instead

ensure that the purchase price of the financed home in is line with

historically sustainable price-to-rent ratios, demand sufficient

down payment and eschew interest-only and negative amortization

loans.

Empowering

homeowners to reduce their negative equity through renegotiation

could thus have enormous economic benefit in its own right.

227

The above proposal should not, however, obscure the

broader point: norm asymmetry between borrowers and lenders

creates disincentives for lenders to renegotiate underwater

mortgages and makes it unlikely that lenders will work with

borrowers to address the negative equity issue. Any proposal to

address the problems created by negative equity must account for

this reality – either by addressing the resulting distributional

Lenders would be more inclined to take these sensible

precautions if borrowers were empowered to behave according to

the same market norms as lenders and breach when it is efficient to

do so. This added caution by lenders might in turn help avoid a

repeat of the current housing crisis.

discouraging or restricting households from moving house); A Tversky and D.

Kahneman, Loss aversion in riskless choice: a reference-dependent model, 106

THE QUARTERLY JOURNAL OF ECONOMICS 1039 (1991), (indicating that

individuals are reluctant to move because they do not wish to take a loss on their

home); and A. Henley, Residential mobility, housing equity and the labour

market, 108 ECONOMIC JOURNAL 414 (1998), (finding that twice as many

individuals many would have moved in the early 1990’s in England had they not

been in negative equity); and Fernando V. Ferreira, et. al., Housing Busts and

Household Mobility NBER Working Paper Series (September 2008), available

at SSRN: http://ssrn.com/abstract=1264572 (discussing the correlation between

decreased household mobility and negative equity). See also Louis Uchitelle,

Unsold Homes Tie Down Would-Be Transplants, N.Y. TIMES, Apr. 3, 2008

(noting, “The rapid decline in housing prices is distorting the normal workings

of the American labor market. Mobility opens up job opportunities, allowing

workers to go where they are most needed.” Also noting that labor mobility that

has been seriously hindered by the housing crisis).

226

See A. Henley, Residential mobility, housing equity and the labour

market, 108 ECONOMIC JOURNAL 414 (1998) and Tomas Hellebrandt, et. al., The

Economics and Estimation of Negative Equity, BANK OF ENGLAND QUARTERLY

BULLETIN 2009 Q2 (June 12, 2009).

227

Moreover, to the extent that a mortgage default is relevant to a credit

application, lenders could ask and borrowers could be required to disclose that

information – as borrowers are now required to do even when the default is no

longer reflected in their credit score.

Underwater and Not Walking Away

52

inequities or changing the rules of the game. Viable approaches

could include: (1) cutting lenders out of the picture altogether

through government financing of mortgages at low interest rates;

(2) using stimulus funds to buy down the mortgages of underwater

homeowners;228 (3) forcing lenders to reduce mortgage balances

by court order; or (4) leveling the playing field by eliminating the

ability of lenders to trash a borrower’s credit score in retaliation for

the borrower’s exercise of his contractual right to default.229

Regardless of the precise policy prescription, it is time to

put to rest the assumption that a borrower who exercises the option

to default is somehow immoral or irresponsible. To the contrary,

walking away may be the most financially responsible choice if it

allows one to meet one’s unsecured credit obligations or provide

for the future economic stability of one’s family. Individuals

should not be artificially discouraged on the basis of “morality”

from making financially prudent decisions, particularly when the

party on the other side is amorally operating according to market

norms and could have acted to protect itself by following prudent

underwriting practices. The current housing bust should be viewed

for what it is: a market failure – not a moral failure on the part of

American homeowners. That being the case, it is time to take

morals out of the picture and search for an equitable solution to the

negative equity problem.

228

See Rebel A. Cole, The Housing-Asset Relief Program: A Plan for

Stabilizing the Housing and Securities Markets (April 22, 2009). Available at

SSRN: http://ssrn.com/abstract=1338883 (proposing that “$300 billion in TARP

or stimulus funds” be “used to write down the principals on underwater

mortgages.”)

229

This limit on credit reporting should also, as discussed above, be

combined with a national anti-deficiency statute and an extension of the tax

waiver for forgiven mortgage debt.