A new study from economists at the Federal Reserve Board aims to answer that question. The research found that the median borrower who “strategically” defaults doesn’t walk away from the mortgage until the amount owed exceeds the value of the home by 62%.
The study is bad news for the mortgage industry in that it backs up the idea that a growing share of borrowers are walking away from loans. Concerns are mounting among lenders and investors that some borrowers who owe far more than their homes are worth are now choosing not to pay mortgages that they can afford.
But the silver lining here is that it suggests a rather high threshold for borrowers to walk away.
“The fact that many borrowers continue paying a substantial premium over market rents to keep their homes challenges traditional models of hyper-informed borrowers” choosing to simply walk away, the authors write. The results suggest “that borrowers face high default and transaction costs” that make strategic defaults less widespread than they might otherwise be.
The study examined borrowers in Arizona, California, Florida and Nevada who bought homes in 2006 with no money down. Nearly 80% of those borrowers had defaulted by September 2009. The authors then separated out defaults caused by job loss and other income shocks from those that had been spurred simply by negative equity.
Nearly 80% of all defaults in the sample resulted from the traditional combination of income shocks and negative equity. But for borrowers that had a loan-to-value ratio of 150%, half of all defaults were strategic defaults, driven purely by negative equity.
Most defaults are typically driven by a combination of income shock and negative equity, or what’s known as the “double-trigger” hypothesis. While borrowers who lose their jobs but have equity in their homes can sell and avoid default, those without any equity are left with fewer options.
“Borrowers do not ruthlessly exercise the default option at relatively low levels of negative equity, broadly consistent with the ‘double-trigger’ hypothesis,” the authors write. “But by the time equity falls below -50%, [half] of defaults appear to be strategic.”
(Read about a separate study released on Monday that finds that around one in five mortgage defaults could be considered “strategic.”)
Empirical evidence suggests that more borrowers may be walking away from their primary residences, but this is a much bigger problem in housing markets that saw stunning home-price gains followed by a free fall. Look to the desert suburbs of Phoenix and Las Vegas, the southwestern coast of Florida, and the far-flung exurbs of California’s San Joaquin Valley and Inland Empire.
The Fed study finds, as have others before, that borrowers are more likely to walk away from homes in states where lenders can’t sue them for a deficiency judgment. The median borrower in a state where lenders have recourse to borrowers’ assets, such as Florida or Nevada, defaults when he or she is 20 to 30 percentage points further underwater than the same borrower in a non-recourse state, such as Arizona or California.
Borrowers with higher credit scores also find it more costly to default. The median borrower with a credit score between 620 and 680 walks away when their loan-to-value ratio hits 151%, while the median borrowers with a credit score above 720 walks away with a loan-to-value ratio of 168%.