Breaching the Mortgage Contract: The Behavioral Economics of Strategic Default

Abstract

This paper asks when people think of foreclosure as a penalty for a serious legal and moral violation, and when they think that handing over a house is an acceptable alternate performance of the loan obligation. I use experimental methods from psychology to demonstrate the effects of social contagion, reciprocity norms, and social distance on ordinary citizens’ moral intuitions about strategic default on a mortgage contract. The central premise of this paper is that when homeowners are deeply underwater, foreclosure is a “weak sanction," and that in turn, we may be able to draw on the insights of behavioral research on the effect of small penalties on cooperation. Psychological and behavioral research has shown that people are more willing to breach contracts that contemplate and specify the consequences of breach within the contract itself. Mortgage contracts have always done this - the consequence for default is foreclosure. I argue that the moral norm against strategic default will be sensitive to shifts in the lender-borrower relationship brought about both by changes to the mortgage contract itself and by exogenous social factors. I use short scenario studies to show empirically that informal norms matter in the mortgage context. First, the increasing frequency of foreclosure means less social stigma around default and in turn erodes the moral constraints on default. Second, reciprocity norms are weaker when banks are perceived as predatory or greedy. Finally, moral aversion to default decreases with social distance: people are less likely to cooperate with faceless, distant entities than with local, identifiable parties. In the world of the mortgage contract, people are less averse to default when the promise has been sold.

Keywords: real estate, mortgage, weak sanction, social norm