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Friday, December 21, 2007

Walking Away from the Mortgage Contract

As noted below, lenders are concerned that there has been a change in the willingness of homeowners to walk away from their mortgage contracts. Why is this happening? The decision to walk away from a mortgage can be viewed as an unexercised option contract, and that approach can shed light on the source the change in the number of homeowners choosing to default.

I'm sure most of you know what an option contract is, but just in case, here' a quick review. There are two types of options, calls and puts. A call option gives you the right to purchase an asset at a pre-specified price, called the strike or exercise price. The purchase must be made on or before a specific expiration date. For example, a March call option for Google stock with an exercise price of $75 gives you the option to purchase Google stock for $75 at any time up to and including the March expiration date. It doesn't matter what the actual market price of the stock is, you can always purchase at $75 so long as it's on or before the expiration date (there are actually two types of options, an American call option gives you the option to purchase the stock up to and including the expiration date, a European option can only be exercised on the expiration date, not before).

Options do not have to be exercised, the holder of the option chooses whether to exercise it or not. When would this option be exercised? Suppose the price of the stock increases to $100 after you purchase the option (when the market price of the stock exceeds the strike price it is said to be "in the money"). If you choose to exercise the option and purchase at $75, you could then sell the stock at $100 on the market making a gross gain of $25. Thus, whenever the market price exceeds the exercise price, the option is in the money and can be redeemed for a gain.

The purchase price of the option is called the premium. There are ways to value options and set the premium, and I will skip that, but let's just say that the price of the option, i.e. the premium, is $10 for illustration.

Recapping, you purchase a call option for $10 that allows you to buy the stock for $75 at any time between now and March. Then, after the option is purchased but before the expiration date, the stock rises to $100 so you exercise the option making a profit of $25-$10=$15. [If, on the other hand, the price never rises above $75 before expiration date in March, the option will be left unexercised and you will lose your $10.]

A put option is just the opposite, an option to sell rather than buy at a specified price on or before a specified date. For example, you might pay $10 for the right to sell the stock at $75 at any time through March, i.e. you hold a March put option. In this case, the option will be exercised only if the stock price falls below the exercise price. Thus, if the price falls to $50, you can buy the stock for $50 on the stock market, then turn around and sell it for $75 according to the option contract realizing a profit of $25-$10=$15. However, if the price stays above the exercise price, the option will remain unexercised through the end of the contract. [If my quick explanations aren't clear, the Wikipedia explanations linked above might help.]

Now, how does this relate to walking away from a mortgage? A mortgage contract grants an implicit call option contract to the borrower. [Any non-recourse loan backed by collateral has this property. A non-recourse loan means the lender may not sue the borrower for further payment beyond the value of the collateral even if the collateral is not enough to cover the loan]. To put the mortgage in option terms, think of the borrower as turning over the collateral (the house) to the lender with the option to reclaim the collateral by repaying the loan. If the loan is not repaid, if the borrower uses the option to walk away, then the lender keeps the collateral (is stuck with the house).

When should the borrower walk away? If the value of the loan is less than the value of the collateral, the best option for the borrower is to leave the option unexercised, i.e. to walk away without using the option to repay the loan and claim the collateral (you want the house only if it's worth more than the loan). I should note, however, that this abstracts from any future reputational effects (i.e. a bad credit rating in the future represents a cost that must be considered) or ethical behavior (you pay the loan even if it costs more than the collateral is worth to honor the contract you signed). That is, this is the case where the borrower and lender agree in advance that walking away is not a sign of bad faith. If that is not true, if walking away has future costs or is constrained by ethics, this must be considered in the analysis. But both the reputational and ethical effects are easy to incorporate, it just means that the loan value must exceed the collateral value by some critical amount (by the value of losing reputation or behaving unethically) before the borrower will choose to walk away from the contract.

Interestingly, there are indications that the reputational or ethical effects are becoming less of a constraint to borrowers walking away:

Jingle mail, jingle mail, jingle mail — eek!, by Paul Krugman: Via Calculated Risk: The WSJ reports that homeowners whose mortgages are bigger than their houses are worth are starting to walk away from their houses, even if they could afford the mortgage payments. ...

Here's a bit more from CR:

One of the greatest fears for lenders (and investors in mortgage backed securities) is that it will become socially acceptable for upside down middle class Americans to walk away from their homes.

See these comments from Bank of America CEO Kenneth Lewis via the WSJ: Now, Even Borrowers With Good Credit Pose Risks

"There's been a change in social attitudes toward default," Mr. Lewis says. Bankers typically have believed that cash-strapped borrowers would fall behind on their credit cards, car payments and other debts -- but would regard mortgage defaults as calamities to be avoided at all costs. That isn't always so anymore, he says.

"We're seeing people who are current on their credit cards but are defaulting on their mortgages," Mr. Lewis says. "I'm astonished that people would walk away from their homes." The clear implication: At least a few cash-strapped borrowers now believe bailing out on a house is one of the easier ways to get their finances back under control.

... there is a new class of homeowners in name only. Because these people never put up much of their own money, they don't act like owners, committed to their property for the long haul. ...

So, there are three separate factors that could contributing to the increase in homeowners walking away from mortgage contracts, a fall in the price, a decreased concern with future reputation, and a decline in ethical behavior. Obviously the fall in price is a big factor, and it appears that an unexpected fall in the ethical or reputational effects may be contributing as well.

The last question to ask, I suppose, is why has there been a decline in the stigma from walking away? One potential reason is that the news media has played this as largely arising from predatory behavior by lenders, and therefore going into default is not seen as a personal failing as in the past, but rather as being a victim of unscrupulous behavior. Second, mortgage problems are being reported as widespread, not isolated, and the "everyone else is doing it" effect lessens the stigma. Third, that a more general decline in social behavior has caused what's individually rational from an economic perspective to be valued more, and concerns based upon the social stigma from being a "deadbeat" valued less. That is, general societal changes have caused individualism to become more important, and social interactions (e.g. what other people think of you)  less important. But I'm not so sure about the last one, or that the three together capture all of the reasons for the change in behavior. Any other ideas?

    Posted by on Friday, December 21, 2007 at 12:24 AM in Economics, Housing | Permalink  TrackBack (0)  Comments (73)

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