First In Trouble — and Last Out

Why are the homeowners who can most benefit from strategic default on underwater mortgages the least likely to choose it?
September 25, 2012 | Research Feature
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One major finding of behavioral economics and psychology of the last 30 years is that people discount the future — specifically, their financial future — differently than standard economic theory predicts they should. Their choices are not shaped so much by rational self-interest as by emotions and psychological biases — biases that often lead people to make decisions that conflict with their self-interest. For example, behavioral economists and psychologists have consistently shown that most people are prone to choose a smaller amount of money today rather than wait a week or two for a little more, even when the larger amount later represents a substantial increase when measured as an annual interest rate.

Nowhere have the consequences of this present bias been more profound than the crisis precipitated by the bursting of the housing bubble. Professor Eric Johnson and his co-researchers, John Payne of Duke University and Columbia Business School doctoral candidate Stephen Atlas, used old and new economic models to understand the mortgage choices that American homeowners made while the housing bubble inflated. They were particularly interested in learning whether homeowners ending up in underwater mortgages — houses for which the market value is less than the remaining mortgage debt — were taking the option of strategic default, walking away from their mortgage and their house to allow ownership to revert to the bank.

The researchers first used an online tool to measure mortgage holders’ time preferences— that is, how much or little people value the future compared to the present. (Listen to Eric Johnson explain more about how time preference works.) They used a method that Johnson developed with Professor Olivier Toubia and their colleagues Theodoros Evgeniou of INSEAD and Philippe Delquie of George Washington University that works much like the adaptive-format SATs, calibrating subsequent questions based on answers to the current question to reduce the total number of questions asked of participants without sacrificing accuracy. The survey asked participants what kind of mortgage they had, whether they were underwater, and, if so, by how much and whether or not they intended to default. With help from Professor Chris Mayer and the Paul Milstein Center for Real Estate, the researchers were able to use zip-code level mortgage data from Zillow and Black Box to verify the average underwater value of homes reported by participants.

The first result did not surprise the researchers: people who are impatient and have present bias — valuing the present more than they value the future — tended to pick low- or no-down payment mortgages with adjustable rates in which lower interest rates and lower payments come first, increasing over time. The lending environment also enabled them to borrow more to buy larger houses. In other words, present-biased homeowners postponed pain.

The second result was more surprising. The researchers expected the present-biased underwater mortgage holders to report a greater likelihood of strategic default because the financial consequences of default are less painful in the present than remaining in an underwater mortgage. “But the very same people who were present-biased told us they were less likely to walk away from their mortgages,” Johnson says. “After we thought about it a while, it started to make sense. What are the benefits of walking away from a mortgage? In the long term, lower housing costs are likely because you’ll probably rent a cheaper house or apartment. But what happens up front is painful: pulling your kids out of school, the possible embarrassment of moving, the cost of packing up, moving, leaving. So even when they are underwater, impatient people in troubled mortgages were less likely to walk away to get themselves out of the mortgage.” And other factors were less important than the researchers expected. For example, many commentators have speculated that some homeowners’ belief that it is immoral to walk away would predict intent to do so — but the researchers found no relationship in their study.

These results may help many a perplexed economist understand why — despite that at least 20 percent of American homeowners hold underwater mortgages — surprisingly few have opted for strategic default. “We tend to expect that people who aren’t financially sophisticated get themselves into trouble quickly and look for ways to get themselves out very quickly,” Johnson says. “But that is not what our data is saying, and, in fact, that doesn’t seem to be what’s happening.”

A house abandoned in the current market can lose value. Banks stand to lose less money when they renegotiate and make settlements that allow people remain in their houses rather than foreclose — something many present-biased homeowners could experience if they don’t choose strategic default. “There is an interesting balance,” Johnson says. “Banks don’t want to devalue the loan. At the same time, they don’t want to have people walking away and leaving the houses empty.”

Recognizing this, banks and consultants are experimenting with offering monetary incentives to keep people in their homes. One firm pays people thousands of dollars to stay in their homes — but not until the mortgage is paid off. “That’s likely to be ineffective for people who don’t value their future as much as they value their present,” Johnson notes. “The more appropriate thing would be to give smaller rewards or benefits every time they make a mortgage payment, and there are firms taking this approach. Our analysis says that it’s the short-term benefits that will keep people in their homes, not the long-term benefits.”


Eric Johnson is the Norman Eig Professor of Business in the Marketing Division at Columbia Business School.

Olivier Toubia is the Glaubinger Professor of Business in the Marketing Division at Columbia Business School.

Eric Johnson

Eric Johnson is a faculty member at the Columbia Business School at Columbia University where he is the inaugural holder of the Norman Eig Chair of Business, and Director of the Center for Decision Sciences. His research examines the interface between Behavioral Decision Research, Economics and the decisions made by consumers, managers, and their implications for public policy, markets and marketing. Among other topics...

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Olivier Toubia

Olivier Toubia is the Glaubinger Professor of Business at Columbia Business School. His research focuses on various aspects of innovation (including idea generation, preference measurement, and the diffusion of innovation), social networks and behavioral economics. He teaches a course on Customer-Centric Innovation and the core marketing course, in the MBA and Executive MBA programs. He received his MS in Operations Research and PhD in...

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Read the Research

Olivier Toubia, Eric Johnson, Theodoros Evgeniou, Philippe Delquie

"Dynamic Experiments for Estimating Preferences: An Adaptive Method of Eliciting Time and Risk Parameters"


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