9. Psychology of Regret

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CHAPTER

NINE

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Psychology of Regret

It’s an old bankers’ axiom, “your first loss is your best loss.” Or put another way, don’t follow good money after bad. The same applies to homeowners. As hard as it is emotionally to do, walking away from the down-payment you made going in when you purchased and the monthly payments made were your best loss. Feeding the loss by making payments each month is just spending good money after bad.

Based upon personal account from 350 underwater homeowners, The University of Arizona’s Prof. Brent White contends that the decision to strategically default is driven by emotion and defaulters are not homo economicus. In his paper “Walking Away: The Emotional Drivers of Strategic Default,” White writes that the elderly, the highly-educated and those with high credit scores are more likely to walk away. Most all attempt to negotiate a modification with their lender and are turned away at the door because they are current on their payments or if they are invited to pursue a modification, the “process turns out, however, to be immensely frustrating and ultimately unsuccessful for many homeowners.”

Research has shown that investment decisions are driven by biases locked in the human brain and humans are especially loss-averse and tend to rationalize bad investment decisions. David Genesove and Christopher Mayer write in a chapter entitled “Loss-Aversion and Seller Behavior: Evidence from the Housing Market” from Advances In Behavioral Economics, “housing professionals are not surprised that many sellers are reluctant to realize a loss on their house.”

These authors found that during the boom and bust in the Boston downtown real estate market of 1990–97, sellers subject to losses set higher asking prices of 25–35% of the difference between the expected selling price of a property and their original purchase price. “One especially successful broker even noted that she tried to avoid taking on clients who were facing ‘too large’ a potential loss on their property because such clients often had unrealistic target selling prices,” write Genesove and Mayer.

And the cold, hard realities of the market are slow to change sellers’ minds according to Genesove and Mayer. According to their data, lower prices and increased time on the market do not significantly influence loss-aversion.

Dražen Prelec and George Lowenstein believe that people do an accounting in their heads that affects their behavior. The linkages tying together specific acts of consumption with specific payments “generates pleasure or pain depending on whether the accounts are in the red or in the black.” In an article entitled “The Red and the Black: Mental Accounting of Savings and Debt” which appeared as a chapter in Exotic Preferences: Behavioral Economics and Human Motivation, the authors’ modeling predicts that most people are debt averse and show “that people generally like sequences of events that improve over time and dislike sequences that deteriorate.”

Prelec and Lowenstein’s work reflects a preference for prepayment, making the enjoyment of the purchased product unencumbered. They write, “one might want to avoid the unpleasant experience of paying for consumption that has already been enjoyed,” and point out that a major economic loss diminishes subsequent utility from consumption. Just as utility from consumption is undermined by the disutility of making payments, the disutility of making payments is buffered by the imputed benefit derived from each payment.

The work of these behavioral economists helps shed light on why some homeowners who are underwater keep paying. They believe the benefits of staying and consuming (if you will) the house outweigh the amount of the payment. But when the hole becomes too deep the increasing numbers of borrowers begin to feel like they are paying for nothing. They don’t feel the benefit of increasing equity, but only the pain of making the monthly payment.

Economist Richard Thaler has found that people are irrationally regret averse. In an experiment where respondents had the choice of being a person who wins $100 in one scenario or a person who wins $150, but was just short of winning $1,000 in another, most people said that they would rather win the $100 and not have to deal with the regret of just missing the $1,000 windfall.

“People tend to experience losses even more acutely when they feel responsible for the decision that led to the loss; this sense of responsibility leads to regret,” explains Hersh Shefrin in Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing.

Humans distort and misremember past events and decisions, hanging on to losing stocks, unprofitable investments, failing businesses, and unsuccessful relationships, rationalizing our past choices, while unfortunately “those rationalizations influence our present ones,” Michael Shermer writes in The Mind of the Market.

Underwater homeowners aren’t walking away because they feel a duty to satisfy their lenders. It’s because they don’t wish to feel regret.

While driving the author to the airport in Las Vegas in late 2010, a cab driver told of buying a house in northwest Las Vegas for $180,000 and improving it with a pool and landscaping. At the height of the boom it was worth $360,000, but had fallen in value to only $140,000 according to the driver. He owed $250,000 and while he and his wife were paying on the note, they quit watering the landscaping and stopped having the exterminator spray for bugs. He and his wife were attempting to do a modification “and would see how that worked out.” But as we arrived at McCarran International, he said with certainty, “the market will come back in three years and then we can sell it.”

Individual lenders suffer from the same ownership biases that borrowers do. Bankers judge their loan portfolio quality to be higher than it really is, just as homeowners believe their particular homes are worth more than the other homes on their block.

The way Duke University rations its limited number of highly-prized basketball tickets serves as an on-going experiment testing this ownership bias. This rationing process, explained in detail by behavioral economist Dan Ariely in his book Predictably Irrational, involves multiple students, is time-consuming, random and complicated. A Duke student may have camped out and completed the entire ticket ritual but end up empty-handed and watching the game on TV.

After a lottery was completed, Ariely recounts trying to buy tickets from those students lucky enough to win the ticket lottery and in turn sell those tickets. When he approached a dejected student who hadn’t won a ticket to the final four basketball tournament, $175 dollars is the most the student would offer.

Next Ariely approached a Duke student who had secured a final four seat and wondered how much money he wanted for it. At first the lucky ticketholder said that he wouldn’t sell no matter the price. After some urging he said he’d take $3,000. When told that was way too high, he agreed to sell his ticket for $2,400.

Ariely and his research partner Ziv Carmon talked to a hundred students on the buy and sell sides to determine the market price. The potential buyers (all of whom participated in the Duke ticket lottery ritual) would only offer an average of $170 for a ticket while on average the sellers demanded on average $2,400 per ticket.

As Ariely explains, as owners we “focus on what we may lose, rather than what we may gain.” The aversion to loss is a strong emotion, Ariely points out, who also explains “that we assume other people will see the transaction from the same perspective as we do.”

It’s a wonder markets ever clear. And in the case of the burst housing bubble, the process was slow and painful, as government kept lenders in business though capital injections, nationalization and accounting rule gimmickry. With their ownership biases running wild, lenders were reluctant to make rational deals with their borrowers and the government enabled this faulty decision-making through force.

Underwater homeowners aren’t walking away because they feel a duty to satisfy their lenders. It’s because they don’t wish to feel the regret of buying at the top of the housing market using too much debt. And instead of doing the financially rational thing and walking away, some keep paying, rationalizing that they are duty-bound to pay the note until the bitter end, but secretly hoping their financial acumen will be resurrected by a rally in home prices. A prospect that in many cities is hopeless.

At the same time, lenders are viewing their mortgage collateral values through rose-colored glasses, with the government backstopping their biased decisions.