When you ain’t got nothing, you got nothing to lose

NYT: Lesson from the Great Depression: [very much NOT an article by Nobel Prize winner Krugman!]

As shown by a 1999 study by  Martha Olney, a professor at the University of California, Berkeley, the Great Depression of the 1930s offers vivid evidence that borrowers default for strategic reasons, and make full payments even on loans that appear “unaffordable” when given the incentive to do so. (Thanks to Song Han at the Federal Reserve Board for pointing me to this study).

During the 1920s boom that preceded the Great Depression, consumer indebtedness grew twice as much as household incomes, which themselves grew significantly. From 1929 to 1933, employment and household income fell many times more than they have fallen in the current recession: If there ever was a time when households could not afford to pay their debts, the Great Depression was such a time.

Indeed, real estate mortgage defaults were common in the Great Depression, and both affordability and strategic default might be cited as reasons. But Professor Olney showed that the incentives for strategic default varied across loan types during the Great Depression, and that default on consumer installment loans made little sense from a strategic point of view.

In the 1920s, it was common for families to purchase automobiles, refrigerators, stoves, and other consumer durables with “installment debt”: that is, they made a down payment of about one-third, took the item home immediately, and promised to make regular payments until the item was fully paid. If the borrower failed to make his payments — even the last one — the item he purchased could be repossessed and he would receive no refund of his prior payments.

In other words, absent the destruction of the item purchased, it was impossible to be “underwater” on the typical installment debt contract of those days, and thus there was no incentive to strategically default.

Professor Olney found that defaults on such contracts were rare in the early 1930s: “Despite the layoffs, the wage cuts, and the unprecedented prevalence of installment credit use, families with installment debt were avoiding default” (pp. 321-2).

Later in the Great Depression, the rules for repossessing consumer durables changed, and consumers had to be given a refund of part of the payments they made prior to default. The incentive to repay installment debt fell, and Professor Olney found delinquencies and defaults on installment debt to rise.

Many people who lost their jobs in the 1930s still made their debt payments, as long as they had an incentive to do. Today homeowners with negative equity have little financial incentive to make their payments. By focusing so much on “affordability,” the Obama adminstration’s latest policies do little to prevent strategic default, and should not be expected to alleviate the foreclosure crisis.

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