Would Jesus Default on His Mortgage Part 2

Richard Thaler, a behavioral economist and a professor at the University of Chicago Booth School of Business, has an op-ed on strategic defaulting. He suggests that Congress pass a law requiring loans to be modified if home prices fall past a trigger point, but that the banks be allowed to share in the upside if (maybe even when) the house is later sold at a profit.

Eric Posner, a law professor, and Luigi Zingales, an economist, both from the University of Chicago, have made an interesting suggestion: Any homeowner whose mortgage is underwater and who lives in a ZIP code where home prices have fallen at least 20 percent should be eligible for a loan modification. The bank would be required to reduce the mortgage by the average price reduction of homes in the neighborhood. In return, it would get 50 percent of the average gain in neighborhood prices — if there is one — when the house is eventually sold.

Because their homes would no longer be underwater, many people would no longer have a reason to default. And they would be motivated to maintain their homes because, if they later sold for more than the average price increase, they would keep all the extra profit.

Banks are unlikely to endorse this if they think people will keep paying off their mortgages. But if a new wave of foreclosures begins, the banks, too, would be better off under this plan. Rather than getting only the house’s foreclosure value, they would also get part of the eventual upside when the owner voluntarily sold the house.

This plan, which would require Congressional action, would not cost the government anything. It may not be perfect, but something like it may be necessary to head off a tsunami of strategic defaults.

It's an innovative suggestion, which I like. I doubt the banks will deal right now, so the solution is for people to start strategically defaulting en masse. Face it, if it was the banks who were buying the houses and we who were lending them the money to do so, they would have strategically defaulted months ago.

As an aside, he cites evidence that the nonrecourse provisions in California and Arizona raised closing costs to the tune of about $800 for every $100,000 that people borrowed. In other words, mortgagees in nonrecourse states have already paid for the right to default and leave the lender no recourse to sue them for the balance. From a solely business perspective, they might as well go and exercise that option - it's as if they bought a put option in investing (a put option being the right to sell a security at a specified price).