October 1, 2010 12:47 pm

Something for the weekend

As fears over the state of the housing market both in the US and the UK continue, a possible solution to slowing the number of mortgage defaults has been suggested by a Wharton academic.

Prof Alex Edmans, a finance professor at the Wharton School at the University of Pennsylvania, has proposed offering a financial incentive, to persuade strategic mortgage defaulters not to abandon their mortgage repayments.

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Prof Edmans points out, that many homeowners in the US who are in negative equity - their mortgage being more than the value of their house - make the strategic decision to default on their payments, walk away from their home and its debts, with a view to starting again.

Offering an incentive programme - Responsible Homeowner Reward - which offers borrowers a cash sum once they repay their entire mortgage could, says Prof Edmans have benefits on both sides.

The homeowner does not incur the expense of moving and neither does his or her credit rating suffer, whilst the mortgage company does not have to pay administration costs and neither does it face the possibility of the empty property being vandalised.

A lot of homeowners are choosing not to continue to make their payments says Prof Edmans, because the value of their homes has dropped so substantially that they feel there is little point in continuing to put money into their home and instead opt for other investments.

“Now, default is a conscious choice. It’s discretionary. We used to think it was automatic - either you had the money or you didn’t,” he says. “But when the default becomes discretionary, the idea of incentives becomes relevant.”

The paper - The responsible homeowner reward: an incentive-based solution to strategic mortgage default was published last month.

It is all too easy if you hold the upper hand to push home your advantage, following the winner takes it all maxim. However an alternative approach, outlined by Horacio Falcao, affiliate professor of decision sciences at Insead, might in the long run be more successful.

He suggests that developing win-win strategies that allow both parties to walk away from the encounter feeling that they both have something of value, might be a better outcome and may well create something of more enduring value.

The use of power, where one person holds all the cards says Prof Falcao can be very destructive. If one individual resorts to power play to win, the counterpart may also try to do the same, leading to resistance and difficulties in pushing through ideas.

“Therefore more power doesn’t necessarily translate into value,” he says. Instead, negotiators should try to endeavour to achieve value - through exploring interests, creating options and then claiming some of the value of the outcome for themselves.

Working together he says can have benefits for all parties concerned.

The full article - can be found at Insead Knowledge.

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