Academic journal article The Journal of Real Estate Research

Lender Characteristics and the Neurological Reasons for Strategic Mortgage Default

Academic journal article The Journal of Real Estate Research

Lender Characteristics and the Neurological Reasons for Strategic Mortgage Default

Article excerpt


In this study, we use functional magnetic resonance imaging (fMRI) to understand how homeowners process non-financial information when considering strategic mortgage default. We find that borrowers initially attempt to inhibit their knee-jerk reaction to retaliate against a lender who has engaged in egregious lending practices when compared to a financially conservative lender. Moreover, when defaults are rare, borrowers are less likely to default because violating the social norm results in feelings of disgust. Finally, when a lender refuses a loan modification, the borrower is found to seek retribution. Interestingly, granting even a modest loan modification removes the desire of homeowners to seek retribution towards their lender no matter what their impression of the lender may be. The results carry a number of policy implications.

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An economic mortgage default is said to have occurred when a borrower can no longer afford to pay his mortgage.1 A strategic mortgage default is when the borrower can afford to continue making payments, but for one reason or another decides not to. Wyman (2010) and Guiso, Sapienza, and Zingales (2013) document that strategic mortgage defaults are on the rise, and FICO (2011) explains that strategic default is a major inhibitor to a recovery of the housing market. Moreover, traditional mortgage models are not equipped to identify / counteract this exercising of a homeowner's put option. As a result, there is a great need in the industry to stem the tide of strategic default incidences.

Seiler (2014) references the ultimatum game literature and uses inequity aversion theory to explain how borrowers are willing to put themselves in financial harm's way to seek retribution against lenders who follow unfair lending practices and / or who have received government bailout funds. He elucidates a number of flaws in the logic process of homeowners who are willing to sacrifice their personal wealth, credit score, and so forth, in order to penalize wrongdoing lenders.

For example, Seiler (2014) finds that borrowers dramatically over-estimate the number of lenders that have engaged in egregious lending practices. Moreover, borrowers do not have a good understanding whatsoever of which lenders did and did not receive government bailout funds.2 Worse yet, the borrowers did not have any idea whether or not their lenders engaged in egregious behavior. Even if they did, he documents the rampant inability of borrowers to differentiate between the servicer of the loan and the underlying owner. This is the most troubling aspect of the study's findings because it implies that if borrowers decide to seek retribution on a lender who they perceive to have behaved egregiously, they will take out their disdain on the wrong institution.3 Misunderstandings of lenders' past behavior coupled with a willingness to seek retribution might well result in a continued downturn in the market and a prolonged economic recession.

Until we better understand what borrowers are thinking and feeling, it is difficult to construct housing policies aimed at effectively counteracting their willingness to seek retribution against their lender through a strategic mortgage default. The purpose of this study is to do exactly this. We use functional magnetic resonance imaging (fMRI) technology to infer what borrowers are feeling in real time as they contemplate strategic mortgage default decisions. Through a controlled environment, this neurological approach allows us to match areas of brain activity with specific aspects of the strategic default decision. This approach also allows us to compare the responses we get through a traditional survey approach (where borrowers share their stated preference) with the revealed preferences that are observed from a neurological examination.4

We first examine trials where borrowers are turned down for a loan modification. …

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