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Negative equity and foreclosure: Theory and evidence

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  • Foote, Christopher L.
  • Gerardi, Kristopher
  • Willen, Paul S.

Abstract

Recent declines in housing prices have focused attention on the relationship between negative housing equity and mortgage default. Theory implies that negative equity is a necessary condition for default, but not a sufficient one. This often-misunderstood result is clearly illustrated in a dataset of Massachusetts homeowners during the early 1990s; fewer than 10 percent of borrowers likely to have had negative equity at the end of 1991 experienced a foreclosure during the following three years. An econometric model of default estimated on two decades of Massachusetts housing data also predicts low default rates for current negative-equity borrowers. We develop a simple theoretical model to interpret these empirical findings and to assess potential foreclosure-reduction policies. Our results imply that lenders and policymakers face an information problem in trying to help borrowers with negative equity, because it is hard to determine which owners really need help in order to stay in their homes.

Suggested Citation

  • Foote, Christopher L. & Gerardi, Kristopher & Willen, Paul S., 2008. "Negative equity and foreclosure: Theory and evidence," Journal of Urban Economics, Elsevier, vol. 64(2), pages 234-245, September.
  • Handle: RePEc:eee:juecon:v:64:y:2008:i:2:p:234-245
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    References listed on IDEAS

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    1. Kristopher S. Gerardi & Adam Hale Shapiro & Paul S. Willen, 2007. "Subprime outcomes: risky mortgages, homeownership experiences, and foreclosures," Working Papers 07-15, Federal Reserve Bank of Boston.
    2. Souphala Chomsisengphet & Anthony Pennington-Cross, 2006. "The evolution of the subprime mortgage market," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 31-56.
    3. Christopher L. Foote & Kristopher S. Gerardi & Lorenz Goette & Paul S. Willen, 2008. "Subprime facts: what (we think) we know about the subprime crisis and what we don’t," Public Policy Discussion Paper 08-2, Federal Reserve Bank of Boston.
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    10. Kau, James B. & Keenan, Donald C. & Muller, Walter III & Epperson, James F., 1987. "The valuation and securitization of commercial and multifamily mortgages," Journal of Banking & Finance, Elsevier, vol. 11(3), pages 525-546, September.
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