Thank goodness rogues in the behavioral finance area have spent the last decade
testing the long-held assumption maintained by economists that people are
(always-generally-usually) rational. Why might the home equity financing vehicle be
under-utilized? Let me throw out a suggestion:
People are often risk averse in situations where they should be risk loving. The
reverse also holds; namely, that people are risk loving in situations that call for
risk aversion. So, what does this mean for home equity financing? Home equity loans
for most Americans constitute a second lien on their primary residence. The amount of
this second lien is of course dependent upon the amount and terms of the first lien.
Is it possible than homeowners, particularly after breathing excessive lawnmower fumes
and being dulled by the monotony of Suburbia, might view the home equity line as
having greater incremental risk than it really has? Option-based theories of loan
performance provide a framework for understanding the relationship between equity and
loan performance on mortgage obligations. Defaulting on a mortgage or home equity
line is actually a put option, in which the borrower has the right (option) to
transfer ownership of (put) the home to the lender (through foreclo!
sure or transfer in lieu of foreclosure) to retire the debts. So you can see, if the
market value of a home falls well below the value of the debts, you’d expect to see
borrowers exercise this option. There are of course transaction costs associated with
exercising this option (namely, credit history and moving expense considerations).
Perhaps homeowners overstate the transaction costs associated with exercising this
option? More likely, perhaps they overstate the risk associated with using up
(through the home equity line) the buffer that exists between the amount of
outstanding debt and the value of their home. After all, the value of their home can
be volatile. In addition, home ownership is viewed as a right (mom, apple pie, and
all that other stuff), societal obligation (access to the country club, putting down
roots, etc), and pre-requisite to other things (children, pets, backyard croquet,
etc.) in many parts of the country. Perhaps placing the home in a position of greater
perceived risk of foreclosure has elements of sacrilege associated with it. I wonder.
Suffice it to say, I think the keys to this puzzle lie in the irrational, not the
New York, NY