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Friday, June 25, 2010

How Underwater Must One Be Before Walking Away?

Three Federal Reserve Board of Governors’ economists recently published a working paper looking at what point do underwater homeowners walk away from their homes even if they can afford to pay. The study found that the median borrower does not walk away until he or she owes 62 percent more than their house’s value.

The study examines borrowers from the states of Arizona, California, Florida, and Nevada who purchased homes in 2006 using non-prime mortgages with 100 percent financing. Default is defined as being 90+ days delinquent for two consecutive months. Of the 133,281 loans in their sample, 78 percent of the loans ended in default by September 2009.

There are two hypotheses in the economics literature that explain mortgage defaults: 1) strategic or ruthless defaults and 2) double trigger default. A strategic default occurs when the borrower believes that the equity in the property has fallen sufficiently below some threshold and decides that the cost of paying the mortgage outweigh the benefits of making the mortgage payment. The double-trigger default hypothesis argues that it is the combination of negative equity coupled with a negative income shock that causes a mortgage default.

While rising interest rates may induce mortgage defaults, the study found that most defaults were not driven by this factor. Fewer than 10 percent of borrowers actually experienced an interest rate increase during the period investigated.

The study also found that borrowers living in Florida and Nevada, which are recourse states, have higher estimated costs of default than those living in Arizona and California. “The median borrower in the recourse states defaults when he is 20 to 30 percentage points more underwater than the median borrower in the
non-recourse states.” This outcome would suggest that borrowers take into consideration potential legal liabilities resulting from a foreclosure when determining when to walk away from a mortgage.

The authors found that “the odds of default increase monotonically as borrowers fall deeper underwater. For example, equity between -1 and -9 percent does not substantially elevate the odds of default relative to zero equity, whereas equity below -60 percent more than doubles the odds of default.”

In conclusion, while strategic defaults are common, borrowers do not exercise this option at low levels of negative equity.

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