Hanging Up the Walkaway Myth

The biggest problem in talking about the supposed walkaway phenomenon was that nobody had any substantive data to back up one claim or another. (Though I made a spirited attempt here.)

Now, a trio of Boston Federal Bank economists have obtained a Massachusetts deed registry dating back to the previous housing downturn to see how homeowners responded when their home equity turned negative. (You can find the research here and here.)

Between 1988 and 1993, home prices in Massachusetts fell by 22.7 percent and foreclosures reached their peak in 1992. With many analysts forecasting that the current foreclosure cycle will zenith at the end of this year or in early 2009, the researchers looked at foreclosures in 1991 for a proxy of what might happen to homes that were underwater at the end of 2007.

An estimated 100,300 borrowers were underwater in Massachusetts in 1991, write Christopher Foote, Paul Willen and Kristopher Gerardi of the Federal Reserve Bank of Boston. Of these borrowers, only 6.5 percent, or 6,500, ended up in foreclosure in the following three years.

For the fourth quarter of 2007, the researchers estimate that 94,000 Massachusetts borrowers were underwater, roughly 10 percent of the state's mortgage borrowers. There were many similarities between borrowers in 1991 and 2007 save for one -- the availability subprime mortgages -- so it's very possible that a greater percentage of underwater homeowners could walk away this time around.

But while the probability of defaulting on a subprime loan is much higher than prime mortgages, the researchers forecast that if house prices fall 10 percent over the next three years, only about 8 percent of underwater borrowers will default in Massachusetts. Why is this the case? After all, doesn't it make economic sense to ditch an asset you're losing money on?

The argument here is that default decisions are based on future housing prices, not current ones. If a homeowner expects housing prices to recover in the future, then in many cases it makes sense to hold out for the future capital gain as opposed to defaulting now and getting nothing. This logic holds regardless of whether other housing options are available. For instance, if a home was bought at $500,000 and then subsequently fell to $100,000,

"it is true that the owner ... could default on his mortgage, and buy an otherwise identical house for only $100,000. He would then pay a smaller monthly mortgage payment. However, as long as keeping his current home makes sense given the cost-benefit calculation above, then he should purchase the additional home and rent it out while keeping his current one. The fact that the second house is a "better deal" than the first in no way reduces the profitability of keeping the first one."

The reason that people default is closely tied to their cash situation. If someone can afford to make mortgage payments even if they're underwater, the reasoning above suggests that they will. But if funds are tight, as they likely are for subprime borrowers, then foreclosures become a necessary option. Walkaways, then, don't make a lot of sense to the Fed economists.

Earlier this year, Moody's Economy.com estimated that some 10 million homes would be underwater in June. Extrapolating out the expected foreclosure rate for the U.S. using the Massachusetts rate -- though this likely understates foreclosure rates for states like California, Nevada, Florida, etc., where speculation was high -- means that we should expect 800,000 of underwater homeowners to default in the following two or three years. For comparison, through March, over 400,000 homes had finished the foreclosure process since foreclosures spiked in August of last year, according to data from RealtyTrac.

What all of this means is that a very large portion of underwater homeowners won't foreclose on their homes. And this has implications for a mortgage rescue plan that would try and save homeowners at risk of default. Because it's hard for lenders and the government to identify who will foreclose solely based on equity status, a plan that reduces the principal owed will be "extremely inefficient" as it may encourage many homeowners that wouldn't have foreclosed to seek government assistance. A bill passed by the House last month and one which will reach the Senate floor soon both call for lenders to reduce the principal on at-risk loans.

A more efficient plan, say the economists, would be similar to one proposed by F.D.I.C. head Sheila Bair which temporarily reduces mortgage payments through a rate freeze but keeps the principal level the same. Under this sort of scheme, homeowners who are cash strapped and otherwise would've defaulted would be more likely to stay in their homes.