Inside the Mind of a Mortgage Defaulter

The US Federal Reserve has published a paper that looks at the idea that people who have money and can afford their mortgages will "just walking away" from their houses because they are "underwater. The result of the study is surprising to me. They discover that most people hold on far longer than you would expect. Here is the abstract of the paper:

A central question in the literature on mortgage default is at what point underwater homeowners walk away from their homes even if they can afford to pay. We study borrowers from Arizona, California, Florida, and Nevada who purchased homes in 2006 using non-prime mortgages with 100 percent financing. Almost 80 percent of these borrowers default by the end of the observation period in September 2009. 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.

Two surprises for me. First, 80% of the borrowers did just "walk away" during their study period. And, second, the borrower generally hung on until he lost well over half the "value" of the house before they did finally just walk away.

This second point is reinforced by this bit from the conclusion of the paper:

Our results challenge traditional models of hyper-informed borrowers operating in a world without economic frictions (Vandell, 1995). Many borrowers in our sample bought houses at the peak of a housing bubble, put no money down, and seemingly had little to lose, financially, by walking away once home values dropped. Yet they pay a substantial premium over market rents to keep their homes. More typical borrowers therefore may be willing to pay an even larger premium given that they have likely invested more financially and emotionally in their house. Why borrowers choose to pay this premium is another direction for further research. Anecdotal evidence suggests that some homeowners who bought at the peak of the housing market refuse to believe that their houses depreciated substantially (Forbes.com, 12/10/2009). In this case, we assign a more negative value of equity to a borrower who is behaving as if he is not as severely underwater and we thus overstate the costs of default relative to what the borrower believes them to be. Additionally, borrowers may be loss averse and thus overvalue the prospect of future capital gains (even when the probability of substantial house price appreciation is low) (Kahneman and Tversky, 1979).

They don't speculate what they "transaction costs" are. They mention a few psychological effects: loss aversion, emotional investment, and unwillingness to honestly admit the size of the loss. They don't try to quantify these.

What does all this prove? That people -- unlike "rational" businesses -- do not "cut and run" using a cold economic logic. People stick with their decisions well past the point where cold logic would say they should "cut and run".

So even those who are scorned as immoral and unwilling to shoulder their mortgage "obligation" show a greater amount of a sense of obligation (or self-delusion) and are unwilling to do the coldly "economic" act of just walking away. Amazing.

Here is a comment from Canadian economists:

With a quarter of U.S. mortgages underwater, the Fed must heed the advice of its own research if it wants to prevent a cascade of defaults and the consequent repercussions on the financial system and the economy. Hence, expect U.S. interest rates to remain low for an extended period.

This just reinforces the point that the US will face a "lost decade" from this economic catastrophe. The Obama administration has never faced up to how serious this economic calamity truly is. They've tried to "finesse" the Republican opposition to serious Keynesian stimulus just like they tried to "finesse" the Shirley Sherrod incident. They end up doing the wrong thing by trying to avoid partisan politics. Tragic.

Here is the size of the US housing crisis as presented by Canadian economists:

Even with low mortgage rates, the oversupply of housing units will take years to clear. Net new housing units2 created in the U.S. surged between 2002 and 2006, as homebuilders went on a construction binge, building 9.1 million new homes while the number of households went up by just 5.6 million. Even though housing starts have fallen sharply to roughly 0.6 million new homes annually, with household formation running at about a 1.0 million annual rate, only about 0.4 million of the oversupply will be absorbed each year.

The total value of the U.S. housing stock (single- and multi-family) fell from $23 trillion in 2006 to about $16 trillion since then. Judging from historical ratios of mortgage debt as a percent of the value of housing collateral, which for many years averaged roughly 40%, there is an overhang of mortgages that are insufficiently collateralized. In other words, given today’s value of housing collateral, mortgages outstanding should be roughly $6.4 trillion, about $4 trillion lower than the actual level of just over $10 trillion.

Bottom Line: Perhaps homeowners are patiently expecting house prices to rise again. Human psychology suggests people naturally anchor on the price they paid, or what something was worth in the past, and are reluctant to sell below this level. But if so, they may be in for a long wait.

Prices are likely to be weighed down for some time by a massive oversupply of homes relative to underlying demographic demand. The faster the jobless rate declines, the faster the workoff of the oversupply as household formations rise. Unfortunately, the labour market is not expected to improve quickly.

That means a lost decade. Nobody in the Obama administration is being honest with the population and telling them: it will take a decade before the economy "heals" if we simply stumble along like we are. Why aren't they more honest? Why aren't the on fire saying "look what Bush policies and the voodoo economics of the Republicans have delivered"?