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Fed vs Fed on strategic mortgage default during the financial crisis

Summary:
Suppose you borrowed a lot of money to buy a house but now find it’s worth a lot less than you currently owe. If your lenders only have recourse to the house itself, you might have good reason to stop paying your debts and walk away — even if you’re perfectly capable of making continued payments.After all, your credit rating will take a hit but your net worth will improve significantly as you move from negative home equity to zero home equity. You might also save money by moving somewhere else with lower monthly payments. Since you never lost the ability to pay your debts, only the willingness to do so, your default would be “strategic”.A few years ago, economists from the Federal Reserve banks of Atlanta and Boston wrote an influential paper trying to quantify the importance of these

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Suppose you borrowed a lot of money to buy a house but now find it’s worth a lot less than you currently owe. If your lenders only have recourse to the house itself, you might have good reason to stop paying your debts and walk away — even if you’re perfectly capable of making continued payments.

After all, your credit rating will take a hit but your net worth will improve significantly as you move from negative home equity to zero home equity. You might also save money by moving somewhere else with lower monthly payments. Since you never lost the ability to pay your debts, only the willingness to do so, your default would be “strategic”.

A few years ago, economists from the Federal Reserve banks of Atlanta and Boston wrote an influential paper trying to quantify the importance of these “strategic” defaults. They found that 14 per cent of all the people who stopped paying their mortgages in 2007-9 had “both negative equity and enough liquid or illiquid assets to make 1 month’s mortgage payment”. In their view, this meant that strategic default was a “relatively rare” phenomenon and “not a major factor” compared to people defaulting because they were simply unable to pay.

Their own data didn’t unequivocally support that conclusion, however. For one thing, just over half the people who defaulted on their mortgages between 2007 and 2009 did so even though their incomes grew by more than 5 per cent over the period, about the same as the general population:

Fed vs Fed on strategic mortgage default during the financial crisis

Meanwhile, the default rate for people who never lost their job during the recession but were stuck with houses worth less than their mortgage debts was the same as the default rate for people who lost their job and had positive home equity. Those who remained employed during the recession but had mortgage debts worth at least 120 per cent of their house’s value defaulted at more than twice the rate of people who lost their jobs but retained positive home equity:

Fed vs Fed on strategic mortgage default during the financial crisis

The idea of separating the role of negative equity from changes in employment always seemed a bit odd, though, because the places with the biggest growth in debt before the crisis were also the places with the most negative equity, the most defaults, and the biggest drops in employment.

For example, average household debt in Texas rose by about 50 per cent between 2003 and 2008, but more than doubled in Florida over the same period. During the recession, the unemployment rate in Florida rose by about 8 percentage points, compared to 4 percentage points in Texas. Unemployment during the recession didn’t just happen, but was closely tied to the housing debt binge of the pre-crisis period.

Anyhow, it seems economists at the New York Fed have decided to respond to their colleagues from further north and south, in an intriguing new blog post looking at how borrowers have chosen to prioritise different kinds of debt repayments over time.

Before the crisis, borrowers considered car loans and mortgages about equally important to each other. So if unexpected expenses or hits to income made it tougher to service debt, it was credit cards that were most likely to bear the brunt of default.

This makes intuitive sense. After all, credit card interest rates are typically over 20 per cent, which is far higher than auto loans or mortgages. Meanwhile, most people with mortgages had positive home equity in the years before the crisis, which made mortgage default unattractive. And people with car loans generally need their vehicles to get to work or school.

The NY Fed economists found that pre-crisis changes to the bankruptcy code made people much less likely to default on their credit card debts relative to their auto and mortgage debt, starting around 2004. (The law took effect in 2005 but people began planning for it before then.)

Second, and more relevant for this post, mortgages lost their privileged position as house prices went down. As the recession began, “auto loans become more than twice as likely to be paid when competing with mortgage loans.”

This change in behaviour was not evenly distributed across the country. The places with the largest declines in house prices — and the greatest prevalence of negative home equity — were the ones where mortgage payments fell the most relative to car payments.

Most interesting of all is what the NY Fed found when they looked at the behaviour of borrowers according to their credit scores. People with better ratings were much more likely to adjust their behaviour than those with worse credit. Between 2008 and 2013, these people were likelier to stay current on their credit cards than on their mortgages:

Fed vs Fed on strategic mortgage default during the financial crisis

As they note, their “findings are consistent with strategic default motives”.

So while there were plenty of people who defaulted on their mortgages because they had no choice, it also seems that there were many who did so because it was the rational choice. Choices that make sense for people who owe more than they own, however, can produce severe costs for their neighbours. That suggests we’d all be better off if there were ways to limit the appeal of these strategic defaults. One possibility: more flexible mortgage contracts that would give borrowers protection from big declines in house prices in exchange for greater upside to lenders if prices appreciate.

Related links:
Explaining the pain in Spain — FT Alphaville
How to avoid another housing crisis (maybe) — FT Alphaville

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Matthew C Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist. I have worked at the world’s largest hedge fund and read every FOMC transcript since May, 1987