Negative Equity Causes Half Of All Mortgage Defaults

June 29, 2010 – Anecdotal evidence has been suggesting for some time that many mortgage borrowers will deliberately chose to default when the mortgage exceeds the value of the property.   Empirical research released by the Federal Reserve Board now shows exactly how big a problem strategic mortgage defaults have become for the banking industry.

The Federal Reserve study reveals that when mortgage debt exceeds 150% of the property’s value, “half of the defaults are driven purely by negative equity”.   With property markets showing little evidence of a fast recovery in values, this comes as bad news for banks and other mortgage holders who now face the prospect of continuing defaults by borrowers who have the capacity to make payments.

The Federal Reserve study looked at borrowers who purchased homes in 2006 in Arizona, California, Florida and Nevada, using non-prime financing with zero down payments.  During the subsequent period to September 2009, a shocking 80% of these borrowers had defaulted.  After adjusting for defaults that occurred due to job losses or other income loss, the study found that strategic defaults do not occur until the median borrower owed 62% more than value of the house.  The Fed study further showed that 80% of the defaults were driven by both loss on income and negative equity.  However, when equity falls below 50%, half of the defaults were strategic.

The mortgage industry can find some solace in the Fed’s report since anecdotal evidence had been suggesting that based on purely financial motives, many borrowers were defaulting when negative equity was only 20 or 30 percent.  Citing the high default and transaction costs (economic friction) of walking away from a mortgage, the empirical evidence therefore implies “generally higher thresholds of negative equity than the anecdotes suggest”.  The unanswered question is, at what threshold do the borrowers still paying but at negative equity of 62% decide to walk?  If property values continue to depreciate, many of these borrowers may also decide that the economic benefits of default outweigh the costs.

The Federal Reserve study also noted that “mortgage borrowers tend to view default as immoral, although 17 percent of survey respondents still say they would default if equity declined to -50 percent”.  A national housing survey by Fannie Mae “suggests that nearly 9 in 10 Americans do not believe it is OK for people to stop making payments if they are underwater on their mortgages”.

According to the study, the costs of a strategic default on a mortgage can be substantial and include “damages to one’s credit, legal liabilities, any unplanned relocation costs and emotional costs or stigma”.  In addition, many “recourse” states allow lenders to sue defaulters for a deficiency judgment.

Ironically, many of the well intentioned programs that impose statutory delays on the foreclosure process may increase the incentive for mortgage default. The report notes that:

“It is worth noting that borrowers who default live rent-free until the lender takes possession of the house (property taxes, though, must still be paid by the mortgage holder), strengthening the incentive to default. Furthermore, delays on the part of the lender to foreclose extend states’ mandated preforeclosure period – the amount of time between a notice of foreclosure and when the lender can seize and sell the property.  All told, borrowers are likely able to stay in their homes for at least 8 to 12 months after they stop making mortgage payments”.

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