Legal Versus Psychological Contracts: When Does a Mortgage Default Settlement Contract Become a Contract?

Abstract

This study increases understanding of the mortgage default settlement process by examining how borrowers make decisions during contract negotiations. We explore two main research questions: (1) Do borrowers experience a difference between psychological and legal contracts? and (2) Does inequity aversion, or the dislike of being taken advantage of, influence the willingness of a borrower to withdraw from a mortgage default settlement contract? Our findings suggest borrowers do not conflate legal versus psychological contracts in this setting, a result which contradicts previous research findings. Moreover, as defaulting borrowers appear to place relatively little value on a clean credit report, they do not differentially enter/withdraw from contract negotiations based on a lender’s unwillingness/inability to clear their credit report. These findings, which run counter to conventional wisdom, may well reflect the emerging divide in the U.S. between individuals and large institutions. Specifically, borrowers do not appear to trust lending institutions, nor do they seem to care deeply about conventional underwriting and risk signaling metrics such as credit reports. Thus, in order to successfully and optimally resolve the voluminous magnitude of outstanding, toxic mortgage debt, a revolutionary new approach to negotiating with borrowers that reflects these new norms must be considered. Examination of a second dataset suggests these results are based on the cultural and legal environment in the U.S., and therefore may not be generalizable to other countries.