From our friend Nick at the WSJ:
At what point do borrowers who owe more than their homes are worth decide to stop paying the mortgage?
A new study from economists at the Federal Reserve Board aims to answer that question. The research found that the median borrower who “strategically” defaults doesn’t walk away from the mortgage until the amount owed exceeds the value of the home by 62%.
(the new study uses -62%, JtR math shows $800,000 x -62% = $496,000)
The study is bad news for the mortgage industry in that it backs up the idea that a growing share of borrowers are walking away from loans. Concerns are mounting among lenders and investors that some borrowers who owe far more than their homes are worth are now choosing not to pay mortgages that they can afford.
But the silver lining here is that it suggests a rather high threshold for borrowers to walk away.
“The fact that many borrowers continue paying a substantial premium over market rents to keep their homes challenges traditional models of hyper-informed borrowers” choosing to simply walk away, the authors write. The results suggest “that borrowers face high default and transaction costs” that make strategic defaults less widespread than they might otherwise be.
The study examined borrowers in Arizona, California, Florida and Nevada who bought homes in 2006 with no money down. Nearly 80% of those borrowers had defaulted by September 2009. The authors then separated out defaults caused by job loss and other income shocks from those that had been spurred simply by negative equity.
Nearly 80% of all defaults in the sample resulted from the traditional combination of income shocks and negative equity. But for borrowers that had a loan-to-value ratio of 150%, half of all defaults were strategic defaults, driven purely by negative equity.
Most defaults are typically driven by a combination of income shock and negative equity, or what’s known as the “double-trigger” hypothesis. While borrowers who lose their jobs but have equity in their homes can sell and avoid default, those without any equity are left with fewer options.
“Borrowers do not ruthlessly exercise the default option at relatively low levels of negative equity, broadly consistent with the ‘double-trigger’ hypothesis,” the authors write. “But by the time equity falls below -50%, [half] of defaults appear to be strategic.”
Empirical evidence suggests that more borrowers may be walking away from their primary residences, but this is a much bigger problem in housing markets that saw stunning home-price gains followed by a free fall. Look to the desert suburbs of Phoenix and Las Vegas, the southwestern coast of Florida, and the far-flung exurbs of California’s San Joaquin Valley and Inland Empire.
The Fed study finds, as have others before, that borrowers are more likely to walk away from homes in states where lenders can’t sue them for a deficiency judgment. The median borrower in a state where lenders have recourse to borrowers’ assets, such as Florida or Nevada, defaults when he or she is 20 to 30 percentage points further underwater than the same borrower in a non-recourse state, such as Arizona or California.
Borrowers with higher credit scores also find it more costly to default. The median borrower with a credit score between 620 and 680 walks away when their loan-to-value ratio hits 151%, while the median borrowers with a credit score above 720 walks away with a loan-to-value ratio of 168%.
What is the criteria for determining that defaults “appear to be strategic?”
That’s no surprise considering many people simply won’t walk away. The median point is where 50% of people would walk away. But even if 10% of people under water strategically default, that’s *millions of people*. Thus the more interesting question is to break it down and answer what percentage of people would walk away if they were underwater by 10%? 20%? That question has real application today.
“we find that the median borrower does not strategically default until equity falls to -62 percent of their home’s value.”
…
“However, when equity falls below -50 percent, half of the defaults are driven purely by negative equity. ”
I think we need some sort of Kelvin to Fahrenheit conversion here.
JP2 – I would add to that some sort of recognition that in the real world ‘negative equity’ should also include a measure of the costs typically associated with selling the property (4-6%?) and possibly even those included with buying/renting the next property (3.5% downpayment/security deposit etc).
Since equity is not ‘real’ until you sell – talking about it without including some recognition of the costs associated with making it ‘real’ would seem imprudent. Of course, that would make a whole lot more folk ‘underwater’ which is probably why its not done.
The higher threshold in recourse states suggests that sooner or later there will be a push to go recourse on all mortgages in the US. That will be a doosey of a battle. Basically of course all it does is to force a bankruptcy filing as well with the default. (IF unemployed 6 months or more you can get the old chapter 7 due to low earnings). Its not clear how much the more the BK will do to the credit score after a foreclosure. As pointed out elsewhere, it will likely require that one put down 6 months to a year of rent as a deposit afterwords, but rental housing will be available. (A 1 year deposit gives the landlord plenty of time to evict and handle a bunch of damage)
sparkylab- Generally I use the sales proceeds after all selling expenses, but you are right, the selling price needs to be split to account for selling expenses.
As far as the realized versus unrealized–
I know a guy was wrecked his car. He should have had insurance, but he let it lapse. He owed about $10,000 in the car. He suggested the same thing: It’s not a loss until he sells. I suggested the loss took place already.
This is indeed one of the murkiest areas of accounting. Many people want banks to write the loans down to market value, but of course, there are plenty of other people who point out that market value is not really known until a sale takes place.
No doubt GAAP would require my friend to write down the value of his car, but lenders who delay foreclosure to maintain higher book values?
The other factor not included in this study is TIME. If a person is underwater 30 to 50% for a few years, they may stay in their house figuring the value will come back. If we are in a flat pattern (or even worse) for another five years, with no real end in sight, then more people will simply walk. Life events (job relocation, divorce, etc) often force the issue also, and over five years, a lot of life events can happen.
Those people I know who are underwater, have for the most part been hanging in, because they felt things would improve. If they sense things are not going to improve soon, it could be a whole new ballgame.
Don’t worry. More walk aways are coming. Especially here in metro Atlanta. You can count on it.
Excelling point Mark. The future of this market depends on the psychology of those who are underwater but have not yet walked. Any part of San Diego that has been largely built in the last decade is especially at risk.
Given this study came from the Fed, it’s telling me one thing… they’re going to push for more and more inflationary policy. If home values go up or stay static, it might stave off foreclosures (in addition to the other advantages inflation gives the government in welching on debts).
A study put out by Deutsche Bank ranked GMAC as the top servicer among all prime mortgage servicers based on short sale timelines – six months! The investment bank’s survey showed that a short sale generated a higher recovery than an REO sale.
For “prime” short sales, GMAC was the fastest, followed by CitiMortgage (7.5 months) and Wells (8 months). DB’s study showed that BofA was the slowest with a 13 month short sale timeline. For “subprime” Wells came in first (15 months), followed by HomEq and then Saxon. Option ARM short sale speedsters were EMC, Aurora, and GMAC.
NC Native,
Exactly!
If they don’t generate inflation, it’s a whole new cycle of default-depression-deflation. The ramifications go far beyond the housing market to economic disaster and state, local, and federal governments being unable to pay the bills.
My money is on Zimbabwe Ben.
Also worth noting is that one of the biggest differentiators for how soon people walk away is whether the loan was full-doc or low/no-doc.
For full-doc loans: 50% of people walk when 90% underwater (!).
For low/no-doc loans: 50% of people walk when 53% underwater.
Quite a difference, and a significantly bigger effect than being in a recourse vs. non-recourse state. This study implies that banks don’t have to bother with agitating for recourse laws if they simply require good documentation.
JTR- I don’t think that’s the same “TIME” that MarkinSanDiego is referring to.
If I understand MarkinSanDiego correctly, he’s suggesting that people will continue to pay with the hope that the market will bounce right back, without respect to average selling times. In fact, the expectation is that selling times will go down with prices going up, like the good ‘ole days.
A very nice lady, mother of four, in Phoenix did not take heed to my suggestion that the market could go down further, and that was three years ago. Roughly speaking, the market is down another 50% since then, and she suggested it was down about 33% from peak prices.
She didn’t want to sell at $450k–she “knew” the market would return in a year, or two. It was a sure way to earn $225k.
Now it’s worth closer to $225k, or another $225k down from $450k.
Oh, and what’s worse? She owes about $350k. Now she’s short. Short of buyers. Short of cash. Short of Phoenix employment–she’s moved to a new market, but continues to try and keep up, with the kids and house payment, plus rent in the new market.
She knew it would go up–sure thing!
She asked me what to do recently. I said, you don’t listen; you have all the answers; why don’t you tell me?
It’s like, “I’ll listen to you now that it’s game over.”
She’ll probably be on the list of failures soon enough–she’s approaching the underwater level.
So, in some way, time is included, but we need to make some observations about how fast the market is going down. Also owner’s future expectations about the property’s value is critical.
“The other factor not included in this study is TIME. If a person is underwater 30 to 50% for a few years, they may stay in their house figuring the value will come back. If we are in a flat pattern (or even worse) for another five years, with no real end in sight, then more people will simply walk. Life events (job relocation, divorce, etc) often force the issue also, and over five years, a lot of life events can happen.”… (Mark in San Diego)
I give Mark “Post of the Day” because of what happened to me. (Apologies for the long post.)
I think back to a recent 5-year time span in my life. My husband–who was the best finish carpenter on the planet-and I bought a lot for cash and he designed and we built our dream home in OR (1999),and we had a 30-year fixed mortgage. We moved in and he was still completing the finish work when he was diagnosed with cancer (2000). We had enough in reserves even with health insurance and medical bills, to hang on for two years, and we sold at a huge profit(sold in only 3 weeks) and moved to CA (2002) to be with numerous friends we had known forever. By mid-2004, he was too sick to continue to work and passed away in late 2004. I’ve been renting since 2002 and never bought during the housing bubble.
In almost five years, our lives completely changed. My husband was incredibly healthy and had a cholesterol level of 112. We got life insurance (premium rates) only a few months before the cancer diagnosis, but the company made him take the test twice since they didn’t believe the number. I often wonder what would have happened to our family if he was too sick to finish the house before we could sell or died before completion? What would I have done?
I never imagined that my younger husband would ever get cancer much less die from it. You can have a perfect life and everything changes in an instant with one phone call. In times like this, the last thing on your mind may be a house– whether you’re underwater or not. Five years can be an eternity.
Here’s one of my favorite quote: “Life is unfair, but sometimes it’s unfair in your favor.” At least it was for me…
Since the loan mods consider front-end and back-end LTV. I wonder if the study should only take into account home value. By the way I’m sure that the value perceived by the “homeowner” is way higher then the true value and that may be another reason for sticking with it.
After reading JP2’s comment (#14), I feel even luckier…
JP2,
My comment had nothing to do with Mark’s.
I think you post here too much, and I don’t like your email address.
Perhaps the homes with the greatest declines were the ones that were pushed up the most during the bubble by “toxic” loans. It would seem logical that the people who got in too deep with funky mortgages and little/no downpayment would be the first to walk.
Also, these (usually lower-income) people are the least stable and most likely to move. If you’re underwater but want to move, there is no choice but to “strategically default.”
I think time is a factor, as well as an individual’s tolerance of the pain-in-the-ass-ness of moving, plus emotional attachment to the house. “It’s not a house, it’s a home.” There is an inertia factor here. It takes a lot to overcome such.
Now, for rental properties, none of that really applies. Non-owner-occupied units are the first to strategic default-assuming rents are lower than total monthly costs.
While this discussion is interesting, I still find the 62 percent negative equity number to be somewhat jaw dropping. I know I’m not in CA any longer, but I can’t completely fathom that kind of price drop. We’ve had our declines here too, but nothing on that order of magnitude.
It’s worth noting that the hit to your credit rating is not directly proportional to the percent you’re underwater. To someone a little underwater, that’s a high cost. And if you have any intention of being a renter, it’s going to be a problem if you don’t act fast and move in before your rating drops (and stay there).
The biggest irony is even once you start renting, you’re potentially trapped there because your credit rating might not let you rent anywhere else! It’s like the worst of homeownership (no mobility) and the worst of renting combined! Karma.
Former RB Resident: they didn’t say it in the article’s summary, but the median decline in equity found in the study was about 20%. So it wasn’t that people generally experienced a 62% decline in equity, thank goodness.
Just eyeballing their graphs, it looked like maybe 10-20% of their sample experienced a 62% or more decline. Not sure where you relocated to, but perhaps you have some bedroom communities that are a long commute from the city core that showed nasty price drops.
@Dwip,
I live in the close in DC suburbs. We’ve had a 10 percent decline or so in my zip code. The bedroom communities you mnetioned (McMansions 45 minutes out of town without traffic, 1.5 or so with) have been hammered. I don’t track the the exurbs, but 62 percent is still a large number. unfathomable, really.