The responsible homeowner reward: an incentive-based solution to strategic mortgage default

Finance

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Edmans A

Alex Edmans

2010

Approximately 30% of housing defaults are strategic: the homeowner is able to make the payments but rationally chooses not to do so due to negative equity. This document describes the Responsible Homeowner Reward (“RH Reward”), an incentive plan to deter strategic defaults by increasing the household’s equity. RH Reward is a contingent cash reward, paid to the homeowner only once the loan is repaid. By effectively reducing the LTV of the mortgage, it increases the homeowner’s incentives to retain ownership of the property. Compared to income-based solutions (e.g. payment reductions), RH Reward tackles the homeowner’s balance sheet. In addition, it is an incentive plan that rewards only homeowners who end up repaying the loan. Compared to other balance sheet-based solutions (e.g. principal reductions), RH Reward does not require modification of the existing loan. This allows to be applied to securitized as well as whole loans, and to be implemented rapidly and at large scale without relying on existing servicing resources. In addition, while a principal reduction is a one-time event, RH Reward is a contingent incentive about which the homeowner is constantly reminded; this greater salience likely increases its behavioral impact. RH Reward bears similarities to the idea of compensating CEOs with “inside debt” to deter bondholder expropriation, as documented by recent studies.

Strategic default; mortgages; incentives; behavioral economics; household finance

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