Across the country, many homeowners have faced the devastating realization that the homes they own are now worth less than what they owe the bank. We all know this unenviable situation as being "underwater."
The pervasiveness of underwater homeowners is already fairly well known, particularly when it comes to hard-hit areas like Arizona, Nevada, Florida, and California. What is not particularly well known, though, is exactly why most of these battered borrowers are still making good on their monthly payments.
Why don't they walk away?
An interesting quirk of economics is that the dismal science generally assumes that all agents in an economy work in their own best interest. But this doesn't always happen in real life.
The mortgage crisis is a case in point. For many of the underwater homeowners in today's market, paying down their mortgage isn't really in their best financial interest. Particularly in states like Arizona -- where mortgages are nonrecourse, meaning the lender can't go after any of the homeowner's assets other than the property itself -- it makes little sense to continue paying a large mortgage on a devalued house when comparable rental rates are far below the monthly mortgage payment.
The situation had University of Arizona law professor Brent White scratching his head, and as a result he wrote a very interesting paper on the subject, which University of Chicago luminary Richard Thaler brought to an even broader audience over the weekend.
Come on, everybody's doing it
Among the conclusions White reached is that borrowers are suffering from "norm asymmetry." That's a jargony term for sure, but it basically means that homeowners are being convinced that the "right thing to do" is to keep paying their mortgage -- even if it's not in their best interest. That stands in stark contrast to the financial giants that make these mortgages, which are free to do whatever they need to in order to maximize profits -- and bonuses.
And who's doing this convincing? For a large part it's the financial companies themselves, folks like Bank of America (NYSE:BAC), Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM), and Wells Fargo (NYSE:WFC).
But they're not alone. They've had plenty of help from government officials like Hank Paulson. Back in 2008, Paulson launched a sharp jab against those who would consider walking away from their homes, saying:
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.
Which makes perfect sense, since I imagine Paulson never speculated on anything when he was at the helm of trading king Goldman Sachs (NYSE:GS). And, of course, with de facto ownership of the ill-fated Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE), the government doesn't stand to gain anything at all from persuading homeowners to act against their own best interest.
During the implosion of the housing market, the government has helped massive financial firms and many homeowners who bought houses they never should have qualified to buy in the first place. Meanwhile, responsible borrowers who bought houses they could afford on traditional fixed-rate loans are made to feel as if they are morally bankrupting themselves if they decide to do what is often highly financially advisable.
Why do we have this "norm asymmetry"? Why would we heap guilt onto this particular group? My guess is that if the powers that be answered honestly, that answer would be "because we can."
Thanks to folks like Brent White, Richard Thaler, and homeowners who are already choosing to move against the grain, though, the stigma of walking away from a severely devalued asset may be waning. If this is the case, the big banks and Uncle Sam need to put away the wagging finger and instead actually deal with the situation in a reasonable and sound manner. I'd suggest a confab with White and Thaler as a good first step.
Underwater homeowners have been getting some rotten advice, but they're not the only ones. Check out this terrible advice you should ignore.
Editor's note: A previous version of this story incorrectly stated that law professor Brent White was an economist. We regret the error.
