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When Underwater Homeowners Walk Away

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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