Saturday, December 6, 2008

Homeowners are No Dummies

I expect homeowners to take deliberate steps to make themselves more forgivable: steps that include earning less income and going delinquent on mortgage payments.

There is always a small group of economists who dismiss the importance of incentives like these, and think that the vast majority of people are not really paying attention. I find their attitude to be arrogant, but -- more important -- contrary to the evidence. Bloomberg reports that 1 in 10 homeowners are in foreclosure or delinquent on their mortgage payments. Sure, some of them lost their jobs for reasons beyond their control (employment is down 1.4 from its peak). But not TEN PERCENT! The vast majority of those delinquent or in foreclosure continue to be employed.

The more important factor behind delinquent mortgage payments is that homeowners can get away with it. Yes, they risk losing their house. But a number of people find that preferable to overpaying for the house. They assume, and rightly so, that they can find another house, and find one cheaply.

5 comments:

Jonathan said...

Professor,

Quick question -- In mortgage renegotiations, banks' reservation price is the value of the house on the open market. Presumably most borrowers value their homes at more than current market prices, even if they no longer value them at the present value of their loan. So why aren't these loans being renegotiated without government intervention? Why is the Coase Theorem failing? What are the transaction costs here?

Robin said...

Some regulators and legislators have seriously proposed a mandatory reduction in the size of mortgages and/or interest rates for those who paid little or nothing down and are 90 days delinquent.

Would any fool ever again make a large down payment? Wouldn't those who are only 30 days late have a powerful incentive to skip payments for a couple more months (free rent) and then insist on a special deal?

In other words, you're right again as usual.

Jarda said...

Jonathan,

the problem is asymmetric information and moral hazard. Imagine you have two groups of homeowners - poor (who were hit by a bad shock and honestly cannot pay the full amount), and rich, who can pay but can pretend they are poor by simply stop paying.

The optimal allocation is then to renegotiate the mortgages for the poor to allow them to stay in their houses, and not renegotiate for the rich ones. However, since the bank cannot really observe who is rich and who is poor, everybody will claim that they are poor.

If the group of poor is relatively small, it is more profitable for the bank to bite the bullet, force foreclosure on the delinquent mortgages and accept the losses, while collecting the higher revenues from the non-renegotiated mortgages of the rich.

Some suggest that you can get around the asymmetric information problem by linking the renegotiation to the current income of the homeowner, which is observable. But here is the moral hazard problem so stressed by Prof. Mulligan. Since people do not supply labor inelastically, then a mortgage payment schedule that is increasing in income will induce them to work less and enjoy more leisure.

In this way, you are fighting one inefficiency (losses from foreclosure) by creating another one (increased effective marginal taxes on labor in a situation when you really want to keep people working).

Tino said...

According to the National Association of Realtors survey 9 million home purchases 2003-2008, 24% of the total, were for “investment”, (speculation), purposes.

http://flv.texasgulfcoastonline.com/NAR2008InvestmentandVacationHomeSurvey.pdf

According to the same survey the share of home purchases that were for investment was around 10% in the end of the 1990s. The top year it was 28%, of a larger total of sold homes, mind you, the second home speculative purchases were driving the increase in sold homes, and are likely bearing the largest decrease now.

Ordinary home investors are certainly more responsive to perceived incentives than journalists and some economists may think. Obviously in this case they and their financers turned out to be sophisticatedly stupid, but if a household is financially sophisticated enough to buy a home for investment/speculation purposes they are likely to be responsive also to government incentives.

Indeed, “over 30% of the repossessed houses units are not occupied by the owner.”

http://www.houserepos.net/blog/foreclosure/speculation-by-investors-largely-cause-of-foreclosure-crisis/

If I paid any income taxes I might be upset that they are using my money to bail out speculators who caused this disequilibrium in the first place (last year I paid in about 100 dollars in federal taxes and was rewarded a 700$ “refund”. Apparently to Bush and congressional Democrats it is a core function of government to give away your money to foreigners).

Sheng said...

Jonathan,

Nowadays part of transaction costs by Coase have been formalized as the inefficiency due to moral hazard. Because it's hard to observe people's working efforts, although everyone claims s/he is a "hard worker" in current situations. I haven't seen a single news report nowadays that a worker self declared that s/he was a slacker and deserved the layoff...They may talk so privately, to spouses, for instance...