The real reason borrowers default

Installment LXVII in the long, sad saga of how we got into this housing mess:

Bankers didn’t understand what caused people to default on their mortgages. They assumed that people who had good credit scores and reliable jobs would keep paying, no matter what, because nobody would walk away from a home unless they absolutely had to.

In reality, it’s now clear, homeowners will walk away from a home if they get too far upside down on the mortgage, even if they could keep making payments if they really had to. That’s the finding of an important research paper by the Federal Reserve Bank of Boston that studied foreclosures in Massachusetts from 1989 through 2007. To read the latest version, updated Dec. 7, click here.

Here’s the key information:

*”Homeowners who have suffered a 20 percent or greater fall in house prices are about fourteen times more likely to default on a mortgage compared to homeowners who have enjoyed a 20 percent increase.”

*Homeowners are more sensitive to changes in home prices and the initial loan-to-value ratio than they are to changes in employment conditions, the Boston Fed study found.

This result shouldn’t come as a big surprise. When house prices are rising, people who get into trouble are smarter to sell the house, pay off the mortgage, and walk away with the remaining equity. It’s only when house prices fall below the mortgage balance that it might make financial sense to default. The Boston Fed study explains the decision-making this way: Homeowners weigh the pain of their current cash squeeze against the possibility that their home’s price will eventually recover, putting them back in the black. (I’ve spoken to homeowners who were making exactly that calculation.)

No surprise, either, that default rates are much higher for subprime mortgages. Those borrowers are more likely to have cash-flow problems, so when prices fall they’re the first ones to walk away. Some people, of course, truly can’t pay. Others could, but don’t see the point.

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