Underwater mortgages and mortgage default risk in a recourse market

House prices have risen steeply globally during the late 1990ís and early 2000ís and, since the global financial crisis, decreased again. Meanwhile, household debt has increased to unprecedented heights in many countries. Increased leverage combined with decreasing property prices results in increasing numbers of households finding their mortgages ìòunderwaterí: i.e. the outstanding mortgage debt is higher than the value of the dwelling. Theory predicts that households with underwater mortgages, possibly taking into account certain transaction costs, would default on their mortgage (Elul et al., 2010). Indeed, mortgage delinquency in general and mortgage default in particular is increasing in the U.S. (Guiso et al., 2010). Recourse is a strong deterrent for defaults, which would help explain the low levels of defaults observed outside of the U.S. (Feldstein, 2008). In light of the fact that so many households are underwater, Thaler (2010) believes the default rate in the U.S. is surprisingly low. Development of negative equity is thus a necessary, but insufficient condition to explain mortgage default risk. In fact, Neuteboom (2008) reports recently moved households in The Netherlands, despite higher average leverage, to be not of additional risk; he explains this by the risk assessment procedures of lenders that assure, at least in the short run, the serviceability of mortgage debt. Regional development of negative equity might therefore be only a partial indicator of increased mortgage default risk. In this study we seek to explain what makes households get underwater and to what extent the prevalence of underwater households affects mortgage default risk. We analyze a panel and a quasi-panel dataset covering both pre-crisis and current household information. References in abstract: Elul, R., Souleles, N.S., Chomsisengphet, S., Glennon, D., and Hunt, R. (2010) What ìòTriggersí Mortgage Default? Federal Reserve Bank of Philadelphia Working paper. Feldstein, M. (2008) How to help people whose home values are underwater ìì The economic spiral will get worse unless we do something about negative equity. Wall Street Journal, November 18th. Guiso, L., Sapienza, P., and Zingales, L. (2010) The determinantis of attitudes towards strategic default on mortgages. EUI Working Paper. Neuteboom, P. (2008) On the rationality of borrowersí behaviour: Comparing risk attitudes of homeowners. Thaler, R. (2010) Underwater, but Will They Leave the Pool? NY Times 01/24/2010