Another Problem With Falling Home Prices

While the rising tide of foreclosures, which the latest available data show are up 55 percent from last year, has been the major worry for policymakers during the current housing bust, there is another problem that comes with falling home prices that may at some point need the attention of those in D.C.

According to new research from Fernando Ferreira and Joseph Gyourko of Wharton and Joseph Tracy of the New York Fed, the typical reaction by homeowners to negative equity -- the state where the amount owed on a house is greater than the home's market value -- is not to move out but to stay. Looking at data from California between 1985-2005, the researchers found that those with negative equity were 50 percent less likely to move than those with positive equity.

The reasons for this are not clearly understood, but one theory is that the higher interest rates typical of housing busts make it harder for those in or near negative equity to buy a new home. Another theory from behavioral economics is that homeowners don't want to face up to the fact that their home is now worth less than they bought it for, so they decide to hold on until prices recover.

But regardless of why people are less likely to move when they're in negative equity, there are problems that arise when households can't move as easily as they'd like.

First, employment opportunities become limited if a family can't relocate to take advantage of a better job. The same applies for families who want to move to an area with better schools, or if a household doesn't have the resources to move to a smaller more affordable home. Other recent research has shown that those with negative equity are less likely to invest in the upkeep of their homes, which could potentially harm neighbor's home values. One other effect is that there is less incentive for homeowners with negative equity to support community investments because even though these investments might raise home values, the rise will go to creditors first and not the homeowner.

Of course, the big thing to keep in mind is that the current downturn, with its higher volume of poor-risk and speculator home buying, is different than the ones considered by the study, so the reaction to negative equity may be different this time around. Still, although the researchers don't calculate a dollar amount for the negative effects of reduced mobility, the results imply that there may potentially be a role for the government to step in.