Most Borrowers Don’t Strategically Default Until Deeply Underwater

June 29, 2010 No Comments »

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New research conducted by the Federal Reserve revealed that the median borrower doesn’t strategically default until home equity falls to -62 percent of their home’s value.

In other words, only half of borrowers who are severely underwater actually make the decision to walk away.

The Fed researchers believe “borrowers face high default and transaction costs because purely financial motives would likely lead borrowers to default at a much higher level of equity.”

They also concluded that default is much more common at significantly lower negative equity levels when combined with a negative life event, such as a loss of income.

In fact, roughly 80 percent of defaults in their sample were the result of income shocks combined with negative equity.

“Our results therefore 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,” the paper said.

The Fed noted that many borrowers continue to “pay a substantial premium over market rents to keep their homes,” partially because they refuse to believe their homes depreciated substantially, while also overvaluing the prospect of future capital gains.

However, when equity falls below -50 percent, half of defaults appear to be strategic and driven purely by negative equity.

The study focused on borrowers from hard-hit states like Arizona, California, Florida, and Nevada who purchased homes in 2006 using non-prime mortgages with no money down.

Nearly 80 percent of the borrowers defaulted by the end of the observation period in September 2009.

Of all the defaults in their sample, only about 20 percent were deemed “strategic.”

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