The Mortgage Foreclosure Rage: A Behavioral Perspective

Abstract

Residential real estate foreclosures reached historic records since the 2008 recession in the United States. While other studies on mortgage defaults and foreclosures focus primarily on individual causal factors leading to the outcome, this paper explores the nature and origins underlying these factors from a behavioral perspective. We argue that: (i) failures in mortgage risk management were due to overconfidence, anchoring, and reference-dependence given constraints in quantitative measurements in inter-temporal terms in a reductionist system; (ii) mortgage derivatives with outsized volume made the lending system dependent on a wider range of externalities with significant ramifications, and thereby more fragile given its misleading assumptions of uncorrelated rather than correlated market behavior; (iii) residential mortgage-backedsecurities (MBS) created illusions of control among market participants due to mental framing, myopia, and other limitations of human cognition; (iv) psychological biases were influenced by product design and lending procedures that promote short-term profits unsuited for a home mortgage; (v) product complexity reduces transparency, intensifies ambiguity aversion, self-serving biases, and default contagion that ultimately led to market breakdown and massive foreclosures. This study contributes to the theories in finance and economics through applications of behavioral measures to current market dynamics. It aims to reveal an idealized but biased system given human characteristics leading to failures in the financial and related industries and to inform policymakers on involuntary consequences in the development of home mortgage products that demand more profound reflections in the regulatory reform process.