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The Depth of Negative Equity and Mortgage Default Decisions -- May 2010, FedRes Board, Washington DC

The Depth of Negative Equity and Mortgage Default Decisions -- May 2010, FedRes Board, Washington DC

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Published by FloridaHoss
A central question in the literature on mortgage default is at what point under-water homeowners walk away from their homes even if they can afford to pay.
A central question in the literature on mortgage default is at what point under-water homeowners walk away from their homes even if they can afford to pay.

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Published by: FloridaHoss on Jul 01, 2010
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Finance and Economics Discussion SeriesDivisions of Research & Statistics and Monetary AffairsFederal Reserve Board, Washington, D.C.The Depth of Negative Equity and Mortgage Default DecisionsNeil Bhutta, Jane Dokko, and Hui Shan
2010-35
NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminarymaterials circulated to stimulate discussion and critical comment. The analysis and conclusions set forthare those of the authors and do not indicate concurrence by other members of the research staff or theBoard of Governors. References in publications to the Finance and Economics Discussion Series (other thanacknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.
 
The Depth of Negative Equity and Mortgage DefaultDecisions
Neil Bhutta, Jane Dokko, and Hui Shan
Federal Reserve Board of GovernorsMay 2010
Abstract
A central question in the literature on mortgage default is at what point under-water homeowners walk away from their homes even if they can afford to pay. Westudy borrowers from Arizona, California, Florida, and Nevada who purchased homesin 2006 using non-prime mortgages with 100 percent financing. Almost 80 percentof these borrowers default by the end of the observation period in September 2009.After distinguishing between defaults induced by job losses and other income shocksfrom those induced purely by negative equity, we find that the median borrower doesnot strategically default until equity falls to -62 percent of their home’s value. Thisresult suggests that borrowers face high default and transaction costs. Our estimatesshow that about 80 percent of defaults in our sample are the result of income shockscombined with negative equity. However, when equity falls below -50 percent, half of the defaults are driven purely by negative equity. Therefore, our findings lend supportto both the “double-trigger” theory of default and the view that mortgage borrowersexercise the implicit put option when it is in their interest.
Keywords:
Housing, Mortgage default, Negative equity
JEL classification:
D12, G21, R20
Email: neil.bhutta@frb.gov, jane.k.dokko@frb.gov, hui.shan@frb.gov. Cheryl Cooper provided excellentresearch assistance. We thank Sarah Davies of VantageScore Solutions for sharing estimates of how mortgagedefaults impact credit scores with us. We would like to thank Brian Bucks, Glenn Canner, Kris Gerardi,Jerry Hausman, Benjamin Keys, Andrew Haughwout, Andreas Lehnert, Michael Palumbo, Stuart Rosenthal,Shane Sherlund, and Bill Wheaton for helpful comments and suggestions. The findings and conclusionsexpressed are solely those of the authors and do not represent the views of the Federal Reserve System orits staff.
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1 Introduction
House prices in the U.S. plummeted between 2006 and 2009, and millions of homeowners,owing more on their mortgages than current market value, found themselves “underwater.”While there has been some anecdotal evidence of homeowners seemingly choosing to walkaway from their homes when they owe 20 or 30 percent more than the value of their houses,there has been scant academic research about how systematic this type of behavior is amongunderwater households or on the level of negative equity at which many homeowners decideto walk away.
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Focusing on borrowers from Arizona, California, Florida, and Nevada whopurchased homes in 2006 with non-prime mortgages and 100 percent financing, we bringmore systematic evidence to this issue.We estimate that the median borrower does not walk away until he owes 62 percentmore than their house’s value. In other words, only half of borrowers in our sample walkaway by the time that their equity reaches -62 percent of the house value. This resultsuggests borrowers face high default and transaction costs because purely financial motiveswould likely lead borrowers to default at a much higher level of equity (Kau et al., 1994).Although we find significant heterogeneity within and between groups of homeowners interms of the threshold levels associated with walking away from underwater properties, ourempirical results imply generally higher thresholds of negative equity than the anecdotessuggest.We generate this estimate via a two-step maximum likelihood strategy. In the firststep, we predict the probability a borrower defaults due to an income shock or life event(e.g. job loss, divorce, etc.), holding equity fixed, using a discrete-time hazard model. Weincorporate these predicted probabilities into the second step likelihood function; when esti-
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See Martin Feldstein’s opinion article in the Wall Street Journal on August 7, 2009 and David Streitfeld’sreport “No Help in Sight, More Homeowners Walk Away” in the New York Times on February 2, 2010.
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