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What Is the Rational Default Point for Homeowners?

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While house prices nationally have fallen 30 percent from their 2006 peak, at what point does it make sense for homeowners to default as a rational economic choice? This is the question John Krainer, a senior economist at the Federal Reserve Bank of San Francisco, and Stephen LeRoy, a professor emeritus at the University of California Santa Barbara visiting San Francisco Fed scholar, have tried to answer in a new paper, Underwater Mortgages.

"Given the importance of falling house prices as a factor in defaults, it is natural to ask how far they must drop before it serves the borrower’s rational interest to strategically default, that is, to walk away from a mortgage even in the absence of a life event," the author's write. What, exactly are "life events"? Typically, the life events that can lead to default are job loss, obviously, but also divorce, illness or some other unforeseen occurrence.

Interestingly, unlike much of the popular financial media, the paper doesn't presume that "rational interest" is something which only resides within the corporate entity. In other words, underlying throughout much of the popular media articles on "strategic default" is the presumption of some kind of moral turpitude on the part of the borrower; that is, "rational interest" on the part of the borrower is largely non-existent.

The paper presents two views of underwater mortgages in the United States. The first is the share of mortgages with principal balance exceeding estimated home value as of the fourth quarter of 2000.

The second is the share of mortgages with principal balance exceeding estimated home value as of the fourth quarter of 2009.

The figures speak for themselves and highlight the tenuous nature of the present housing market. So, at what point does it make sense for a borrower to strategically default? The most obvious answer is right at the point at which the house's market value equals the outstanding loan balance. However, the underwater point is not consistent with rational behavior on the part of the borrower, the paper observes. Why?

"To understand why, consider a homeowner who is at the underwater point, with the house value exactly equal to the outstanding balance of the mortgage. Should this borrower strategically default? We argue that the borrower still has incentive to stay in the house. Going forward, the borrower is in a “heads-I-win, tailsyou-lose” position vis-à-vis the lender. If house prices fall further, then the borrower can default immediately, so that declines in house prices translate into losses for the lender. On the other hand, if house prices rise, then the gain accrues to the borrower. With no downside risk, the borrower will not actually be indifferent as to whether to default. Contrary to what many might assume, the borrower will actively prefer not to default. With both upside potential and downside protection against future losses, the borrower rationally should wait before defaulting."

What this analysis shows is that, for rational borrowers, the default decision depends on the market value of equity in the home, and, in turn, the market value of equity depends on the homeowner's expectations about whether the price of the house will recover, restoring positive equity in a book value sense, as well as the overall cost of defaulting. This is critical to understanding the path to strategic default because it demonstrates the many economic factors at stake beyond a simple calculation of home market value vs. outstanding mortgage value.

Ok, so what's the bottom line? The authors conclude that, "Barring life events, borrowers are likely to stay in their houses until they are well beyond the book value underwater mark." And that's true, for now. But, the longer high levels of unemployment persist, the more household balance sheets weaken, the greater the mistrust of the financial system and the more acceptable it becomes to reject credit and consumption as forms of individual expression, the more at-risk the housing economy becomes to increasing strategic defaults. In other words, for every day the present economic malaise persists, the narrower the spread between the underwater mark for households and the rational economic decision to default is likely to become.
POSITION:  No positions in stocks mentioned.