Strategic default and unemployment: What factors affect the likelihood that homeowners will default on their home mortgages?

 
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Buying a new home has long been considered a quintessential part of the American dream. However, the process can be a source of both excitement and stress, as new buyers must balance managing a new property, performing household tasks and coping with mortgage payments. Homeownership can be challenging, as we saw during the mortgage crisis of 2007-2009, when many households found themselves unable to pay their mortgages on newly purchased homes. The crisis dovetailed with the Great Recession and resulted in many foreclosures, leaving lingering effects during the years that followed.

The effects of the crisis are still playing out, with mixed evidence of recovery. U.S. homeownership rates dipped between 2009 and 2015, according to the U.S. Census Bureau. During the fourth quarter of 2009, 67.2 percent of households owned their homes. That number dropped to 63.8 percent in the fourth quarter of 2015. A 2015 report from the Harvard Joint Center for Housing Studies, “The State of the Nation’s Housing, 2015” offers additional insight into the nation’s housing recovery. The report examines falling homeownership rates among various age groups and a growing demand for rental units, especially among individuals aged 45-64 and higher-income households. Meanwhile, an analysis from the Federal Reserve Bank of St. Louis indicates that mortgage delinquency rates have declined considerably since 2010.

In some cases, however, homeowners are refusing to pay their mortgages and allowing their homes to go into foreclosure even when they can afford to pay. This strategy, known as “strategic default,” is generally limited to individuals whose homes have lost value in recent years and, as a result, they owe more on their mortgages than the homes are worth.

A group of researchers led by the Federal Reserve Bank of Atlanta sought to better understand what makes some homeowners more likely to default. In a 2015 working paper for the National Bureau of Economic Research, titled “Can’t Pay or Won’t Pay? Unemployment, Negative Equity, and Strategic Default,” the authors examine the interplay between household finances and mortgage decisions. They add to previous literature on the topic by providing an analysis with more complete data. Whereas prior research relied on aggregate data, such as state unemployment figures, this study uses household-level data from the Panel Study of Income Dynamics (PSID) to assess how job loss, negative home equity and other types of “financial shock” influence homeowner decisions about whether or not to default on mortgages.

The key findings include:

  • More than 30 percent of households that were at least two payments behind on their home mortgage had experienced a loss of employment. The vast majority — 80 percent — of households that had fallen behind in payments “experienced a major shock to their cash flow, including job loss, a severe income loss, divorce, or hospitalization.”
  • Heads of household who had defaulted on their loans exhibited a 21 percent unemployment rate compared to an overall unemployment rate of 6 percent. Spouses in these households had a 31 percent unemployment rate, compared to 13 percent in households that paid their mortgages.
  • Unemployed households with negative home equity — they had a loan-to-value (LTV) ratio of more than 100 percent — had a default rate nearly five times higher than employed households with negative equity. Unemployment has a more pronounced effect when households have more negative home equity.
  • Approximately 19 percent of households that fell into the category of “can’t pay” — meaning that the head of household was unemployed and the household had less than a month’s worth of mortgage payments available in stocks, bonds, or liquid assets – were in default. But the remaining approximately 81 percent of this group managed to remain current on their loans.
  • Strategic default is rare. Less than 1 percent of households that had the ability to pay their mortgages were in default.

The authors note several areas for future research, including a further examination of why households wrestling with unemployment and very limited funds continue to pay their mortgages. The authors state that their research could be used to inform economic policy and improve the process through which mortgage lenders work with homeowners to resolve loans that are in default. “We show that the size of a payment or principal reduction that a lender is willing to offer to a distressed homeowner is increasing in the probability of that borrower defaulting,” the authors state. “Thus, low default probabilities among distressed borrowers reduce the ability of the lender to mitigate foreclosures.”

Related Research: A 2016 study published in the Journal of Housing Economics, “The Perceived Moral Reprehensibility of Strategic Mortgage Default,” examines the conditions under which the public is more and less accepting of defaulting borrowers. A 2015 report from the Joint Center for Housing Studies of Harvard University and Enterprise Community Partners Inc. looks at trends among households that pay more than one-half of their income on rent. A 2014 report from the Congressional Research Center considers how the federal government’s home mortgage interest deduction (MID) varies among states.

 

Keywords: housing, mortgage, home loan, unemployment, jobless, recession,  homeowner, strategic default

Last updated: April 11, 2016

 

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Citation: Gerardi, Kristopher; Herkenhoff, Kyle F.; Ohanian, Lee S.; Willen, Paul S. "Can’t Pay or Won’t Pay? Unemployment, Negative Equity, and Strategic Default,” Working paper for the National Bureau of Economic Research, 2015. NBER Working Paper No. 21630.