When Underwater Homeowners Walk Away

By
Tuesday, June 22, 2010 at 11:14 am

Despite the media and political attention paid to strategic default, we actually don’t know that much about it. The phenomenon is as old as the Great Depression, but has not been common in decades. We do not know how prevalent it has become. We do not know the extent to which the phenomenon is driven by new social acceptance. There is not even a commonly accepted definition of strategic default — what line separates “strategic defaulters,” who can still afford to pay the bank, from plain old defaulters, who cannot? A few thousand dollars in the bank? Any employment income at all?

Federal Reserve economists Neil Bhutta, Jane Dokko and Hui Shan have a new paper bringing the data to bear on those questions. They studied homebuyers from Arizona, California, Florida and Nevada — the states hit worst by the subprime bubble — who took out mortgages in 2006. All of the borrowers took out non-prime mortgages and put no money down. By September 2009, four in five had defaulted.

The study attempts to figure out which underwater homeowners defaulted “strategically,” and why. To do so, it adjudicates between two hypotheses for the motivation for default. The first is that “default occurs when a borrower’s equity falls sufficiently below some threshold amount and the borrower decides that the costs of paying back the mortgage outweigh the benefits of continuing to make payments and holding on to their home” — strategic default, or “the ruthless borrower” effect. The second is the “double trigger” hypothesis: When homeowners are underwater on their mortgage, “default occurs only when combined with a negative income shock,” like job loss or illness.

Here’s the summary of the findings:

After distinguishing between defaults induced by job losses and other income shocks from those induced purely by negative equity, we find that the median borrower does not strategically default until equity falls to -62 percent of their home’s value. This result suggests that borrowers face high default and transaction costs. Our estimates show that about 80 percent of defaults in our sample are the result of income shocks combined with negative equity. However, when equity falls below -50 percent, half of the defaults are driven purely by negative equity. Therefore, our findings lend support to both the “double-trigger” theory of default and the view that mortgage borrowers exercise the implicit put option when it is in their interest.

Additionally, it concludes:

Our results suggest that while strategic default is fairly common among deeply underwater borrowers, borrowers do not ruthlessly exercise the default option at relatively low levels of negative equity. About half of defaults occurring when equity is below -50 percent are strategic but when negative equity is above -10 percent, we find that the combination of negative equity and liquidity shocks or life events drives default. Our results therefore lend support to both the “double-trigger” theory of default and the view that mortgage borrowers exercise the implicit put option when it is in their interest.

Essentially, if still employed and healthy, these homeowners with subprime mortgages did not walk away until they owed $161,000 on a $100,000 home — meaning they would owe the bank something like $61,000 in the case that they sold it. And four in five defaults came from “income shocks,” like job loss. This suggests to me the best way to deal with strategic default remains bolstering job growth and supporting cramdown in areas where home prices have fallen considerably.

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Comments

17 Comments

When Underwater Homeowners Walk Away | We Help With Foreclosure
Pingback posted June 22, 2010 @ 5:00 pm

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Vegas
Comment posted June 22, 2010 @ 10:49 pm

A bunch of people I know did strategic defaults. Right now we owe $221,000 on our house (we put down 20% and have a good rate)and ones like it are now selling for $135,000 (90% of the sales are foreclosures and short sale). It would take 18 years in our house with our mortgage to get to that level. We have to leave in 5 years…..gee I hope something changes


Underwater and the Strategic Default PR Campaign, 1: Fannie and a 7-year penalty. « Rortybomb
Pingback posted June 23, 2010 @ 5:04 pm

[...] Annie Lowrey has a good catch in When Underwater Homeowners Walk Away, with this Federal Reserve paper The Depth of Negative Equity and Mortgage Default Decisions: After [...]


Fannie Mae wants to defer strategic default with consequences
Pingback posted June 23, 2010 @ 5:20 pm

[...] issue is a thorny one because of the challenge to define what makes a default strategic. The Washington Independent reports that strategic defaulters aren’t really breaching their contracts. Every mortgage contract [...]


North Capitol Street » Blog Archive » Fannie Mae Penalizes Strategic Defaulters
Pingback posted June 23, 2010 @ 9:13 pm

[...] would be plain-old defaulters within a matter of weeks or months — particularly given that 80 percent of subprime borrowers who default do so only because of income [...]


Underwater and the Strategic Default PR Campaign, 1: Fannie and a 7-year penalty. » New Deal 2.0
Pingback posted June 24, 2010 @ 11:52 am

[...] Annie Lowrey has a good catch in When Underwater Homeowners Walk Away, with this Federal Reserve paper The Depth of Negative Equity and Mortgage Default [...]


Aid to the unemployed facing foreclosure: Too little, too late … | needtosellmy-house
Pingback posted June 24, 2010 @ 2:40 pm

[...] 58 percent of its applicants cite unemployment as the primary reason for foreclosure. And a recent study by economists at the Federal Reserve shows that four in five subprime mortgage holders who default [...]


Fannie Mae takes aim at defaulting homeowners
Pingback posted June 25, 2010 @ 1:30 pm

[...] exactly is Fannie Mae proposing to judge who can afford to pay their mortgages and who cannot? The research we’ve got on this question concludes that most defaults are driven by house equity falling to [...]


TomBrewhi
Comment posted July 3, 2010 @ 6:17 am

It won't, the market still has another 50% at least to fall. Stop paying your mortgage, save the money and move out when the time comes. You will never see a cent of the money you have put into the house. Sorry


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Rep. John Conyers: My Letter to Secretary Geithner: Fannie Mae Must Stop Bankrolling Lawsuits Against Underwater Homeowners with Our Money | Mortgage Quotes and Loans
Pingback posted September 1, 2010 @ 1:11 pm

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Pingback posted September 1, 2010 @ 3:33 pm

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My Letter to Secretary Geithner: Fannie Mae Must Stop Bankrolling Lawsuits Against Underwater Homeowners with Our Money | The Seminal
Pingback posted September 1, 2010 @ 4:51 pm

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Fannie Mae Must Stop Bankrolling Lawsuits Against Underwater Homeowners with Our Money | BlackNewsTribune.com
Pingback posted October 11, 2010 @ 4:01 pm

[...] far less productive path. It recently announced that it will sue underwater homeowners who “strategically default” on their mortgage [...]


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