Money and Finance

The psychology of the housing mess - By Richard H. Thaler and Cass R. Sunstein

With the housing collapse, human decisions — whether on Wall Street or on Main Street — played a critical role. So it's instructive and, indeed, essential that we understand the human decision-making of today's crisis so that we don't veer down this treacherous road again.
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The first problem is that with respect to borrowing, cultural values have radically changed in the past three decades. For most of the 20th century, most American homeowners had a single-minded goal: Pay off the mortgage. Owning a home outright was every family's dream. If a windfall came their way, people would often use it to pay off that damn mortgage.
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But in the 1990s, this principle dissolved under the pressure of temptation. With house prices rising, families started using home equity loans to finance their spending habits. And as interest rates plummeted, many families refinanced their mortgages to finance more lavish lifestyles. Who could resist the combination of lowering the monthly payment and getting an extra $25,000 to use for a new media room?
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A complicated world
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In normal circumstances, all this borrowing might "merely" have cut into savings rates. That would have been bad enough, because savings has been hovering around zero for the past few years. But when real estate prices began to fall, and variable-rate mortgage payments started to reset, families found themselves in deep trouble.
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Why didn't people foresee the dangers? A key reason is that the choice among mortgage options has become impossibly complicated. With all the bureaucratic mandates, the incomprehensible terms and the fine print, even the most sophisticated borrowers are unable to compare plans.
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Borrowers also fell prey to the pervasive failing known as "extrapolation bias," which is the all-too-human tendency to assume that the current trend will continue forever. Remember when Internet stocks were increasing in value? Many people expected that they could count on continued increases. So what did they do? They put most of their money in technology stocks — and got walloped.
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In real estate, countless Americans caught this fever. Not surprisingly, one of the many markets with the biggest foreclosure problems was Las Vegas, which experienced one of the highest rates of price appreciation in real estate over the past decade.
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The unfortunate group includes homeowners who saddled themselves with mortgages they couldn't pay, and speculators who thought that a good way to get rich was to buy several homes with cheap money.
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The crisis is compounded by what psychologists call "loss aversion." The real estate market is by no means immune to this phenomenon. Numerous studies have shown that humans hate losses much more than they like gains. This means that losing $1,000 hurts you about twice as much as winning $1,000 makes you feel good. In the stock market, investors hold on to losers longer than winners, even though there are tax incentives to do just the opposite.
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How does this play out in the housing market? Reluctant to take less for their houses than their neighbor got just a year ago, sellers tend to keep their houses on the market for far too long. So even as the market began to go south, people foolishly failed to budge.
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For the future, an understanding of these problems offers some important lessons for individuals and government alike. Prudent homeowners should start thinking more like their parents' generation. They should plan to pay off their mortgages by the intended date of retirement; that would be a great start on a retirement savings plan.
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New strategies
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Also, homeowners should beware of extrapolating from current trends. When neighbors start to say prices can only go up because everyone wants to live there, stop listening. A red-hot real estate market tends to usher in what former Fed chairman Alan Greenspan famously called "irrational exuberance."
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People who have a house on the market now would be wise to step back and reassess their strategy. If a house has been languishing for months, it might well be time to accept your fate and lower the asking price. Those who have made bad investments are often tempted to wait until they can recoup their purchase price. That's a mistake.
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For government, the best response is to take immediate steps to ensure that borrowers are able to make sensible comparisons among different plans.
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Mortgage providers today tend to deluge people with fine print and confusing details. Government regulation, which mandates endless pages of complex disclosures, makes the situation even worse. Borrowers feel overwhelmed. They agree, often cluelessly, to the terms placed in front of them.

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Related Book: Nudge: Improving Decisions About Health, Wealth, and Happiness

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