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The depth of negative equity and mortgage default decisions

  • Neil Bhutta
  • Jane Dokko
  • Hui Shan
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A central question in the literature on mortgage default is at what point underwater homeowners walk away from their homes even if they can afford to pay. We study borrowers from Arizona, California, Florida, and Nevada who purchased homes in 2006 using non-prime mortgages with 100 percent financing. Almost 80 percent of these borrowers default by the end of the observation period in September 2009. After distinguishing between defaults induced by job losses and other income shocks from those induced purely by negative equity, we find that the median borrower does not strategically default until equity falls to -62 percent of their home's value. This result suggests that borrowers face high default and transaction costs. Our estimates show that about 80 percent of defaults in our sample are the result of income shocks combined with negative equity. However, when equity falls below -50 percent, half of the defaults are driven purely by negative equity. Therefore, our findings lend support to both the "double-trigger" theory of default and the view that mortgage borrowers exercise the implicit put option when it is in their interest.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2010-35.

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Date of creation: 2010
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Handle: RePEc:fip:fedgfe:2010-35
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  1. Kau James B. & Keenan Donald C. & Kim Taewon, 1994. "Default Probabilities for Mortgages," Journal of Urban Economics, Elsevier, vol. 35(3), pages 278-296, May.
  2. Fernando Ferreira & Joseph Gyourko & Joseph Tracy, 2008. "Housing Busts and Household Mobility," NBER Working Papers 14310, National Bureau of Economic Research, Inc.
  3. 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.
  4. Kristopher S. Gerardi & Andreas Lehnert & Shane M. Sherlund & Paul S. Willen, 2009. "Making sense of the subprime crisis," Public Policy Discussion Paper 09-1, Federal Reserve Bank of Boston.
  5. Adelino, Manuel & Gerardi, Kristopher & Willen, Paul S., 2013. "Why don't Lenders renegotiate more home mortgages? Redefaults, self-cures and securitization," Journal of Monetary Economics, Elsevier, vol. 60(7), pages 835-853.
  6. Quigley, John M., 1993. "Explicit Tests of Contingent Claims Models of Mortgage Defaults," Department of Economics, Working Paper Series qt3df5357v, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  7. Deng, Yongheng & Quigley, John M. & Van Order, Robert, 1999. "Mortgage Terminations, Heterogeneity, and the Exercise of Mortgage Options," Berkeley Program on Housing and Urban Policy, Working Paper Series qt96r560pg, Berkeley Program on Housing and Urban Policy.
  8. Benjamin J. Keys & Tanmoy Mukherjee & Amit Seru & Vikrant Vig, 2010. "Did Securitization Lead to Lax Screening? Evidence from Subprime Loans," The Quarterly Journal of Economics, MIT Press, vol. 125(1), pages 307-362, February.
  9. Andra C. Ghent & Marianna Kudlyak, 2010. "Recourse and residential mortgage default: theory and evidence from U.S. states," Working Paper 09-10, Federal Reserve Bank of Richmond.
  10. Todd Sinai, 1997. "Taxation, User Cost, and Household Mobility Decisions," Zell/Lurie Center Working Papers 303, Wharton School Samuel Zell and Robert Lurie Real Estate Center, University of Pennsylvania.
  11. Patrick Bajari & Chenghuan Sean Chu & Minjung Park, 2008. "An Empirical Model of Subprime Mortgage Default From 2000 to 2007," NBER Working Papers 14625, National Bureau of Economic Research, Inc.
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