Thursday, 9 August 2007

Rational Default

(R.I.P. subprime, alt-A, negative am hybrid arms and all those other delightful mortgage market innovations.)

Over on Calculated Risk, Tanta discusses the behaviour of U.S. home owners given the availability of negative amortisation mortgages. (Essentially an option ARM had very low initial payments, so you could buy a large house with one of these even if you didn't have a large income, then if the house went up in value, sell it before the low interest period ended. If it went down in value, you just defaulted and tried again with a different property. The negative am part is that the reason the interest payments were so low was that some interest was capitalised into the loan amount.
It was the policy makers who didn't recognize rampant speculation in the housing market. While we joked about "liar loans" here on Calculated Risk, the policy makers were congratulating themselves on the "ownership society". I'd argue home buyers who used no money down option ARMs were making a rational choice: they were balancing the odds of a big payday with little financial risk - if the property continued to appreciate - with the stigma of a foreclosure on their record. Obviously many home buyers felt the stigma was worth the risk. I see that as [...] a rational choice given the circumstances.
Now this is interesting: undoubtedly some people did behave this way, but was it a common phenomenon? This is a little like the sovereign default problem I discussed earlier: sometimes it is rational to default. However, just as there nations are held back by the stigma of default, so I suspect many people don't default when they rationally should. This is part of risk aversion, a flipside of the phenomenon whereby students don't go to University despite the availability of deferrable student loans whose repayments are based on income: a risk neutral analysis indicates one course of action, but people are not often risk neutral.

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