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Real Estate Research provided analysis of topical research and current issues in the fields of housing and real estate economics. Authors for the blog included the Atlanta Fed's Jessica Dill, Kristopher Gerardi, Carl Hudson, and analysts, as well as the Boston Fed's Christopher Foote and Paul Willen.

In December 2020, content from Real Estate Research became part of Policy Hub. Future articles will be released in Policy Hub: Macroblog.

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April 18, 2011

What effect does negative equity have on mobility?

A debate has broken out in the housing literature over the effect of negative equity on geographic mobility. The key question is whether homeowners with negative equity—those who are "under water"—are more or less likely to move relative to homeowners with positive equity. In a paper published in the Journal of Urban Economics last year (available on the New York Fed website), Fernando Ferreira, Joseph Gyourko, and Joseph Tracy (hereafter FGT leaving out these categories) argue that underwater owners are far less mobile. Using data from 1985 to 2005, they find that negative equity reduces the two-year mobility rate of the average American household by approximately 50 percent. This is a very large effect and, if true, FGT's findings have important policy implications for both the housing market and the labor market today. For example, the economist and Nobel laureate Joseph Stiglitz, in testimony to the Joint Economic Committee of Congress on December 10, 2009, stated:

But the weak housing market will contribute to high unemployment and lower productivity in another way: a distinguishing feature of America's labor market is its high mobility. But if individuals' mortgages are underwater or if home equity is significantly eroded, they will be unable to reinvest in a new home.

The fear is that if people with negative equity can't move to new jobs, then the job-matching efficiency of the U.S. labor market will suffer, putting upward pressure on the unemployment rate. This type of "house lock" is exactly what the economy doesn't need as it emerges from the recent housing crisis and recession.

However, recent research by Sam Schulhofer-Wohl, an economist from the Minneapolis Fed, casts doubt on FGT's conclusions, as well as the economic intuition in Stiglitz's testimony. Schulhofer-Whol replicated the FGT analysis using the same data set (the American Housing Survey, or AHS) over the same sample period. But he found the exact opposite result: negative equity significantly increases geographic mobility.

What is the source of the discrepancy?
The difference in results stems from what at first blush seems like a small discrepancy in how the two papers identify household moves in the AHS. Here are the details: the AHS is conducted every two years by the U.S. Census Bureau as a panel survey of homes. That means that AHS interviewers go to the same homes every two years to record who lives there (among other pieces of information). For a home that is owner-occupied in one survey year, there are four possibilities regarding its status two years later. First, the home could still be owner-occupied by the same household as before. Second, the home could be owner-occupied by a different household. Third, it could be occupied by a different household that rents the home but doesn't own it. Finally, the home could be vacant.

In their paper, FGT treated the first category as a non-move and the second category as a move. FGT threw out of their analysis any observations that fell into the third and fourth categories.1 Dropping these last two categories, rather than coding them as moves, introduces significant bias into FGT's results. As Schulhofer-Wohl notes, it effectively assumes that households in negative equity positions are no more likely to rent out their homes, or leave them vacant when they move, than are households with positive equity. But it is relatively straightforward to show that this assumption is not borne out in the data. Specifically, Schulhofer-Wohl finds that positive-equity households who move sell their houses to new owner-occupiers two-thirds of the time. The other two possibilities (renting out the home or leaving it vacant) combine to occur only one-third of the time. In contrast, among negative-equity households who move, sales to new owner-occupant households occur half of the time, with the other two possibilities occurring the other half. Thus, by dropping the last two categories of transitions, FGT are artificially increasing the mobility rate of positive equity households relative to negative equity households.

Schulhofer-Wohl recodes the moving variable so that instances in which an owner-occupied home is rented or vacated also count as moves. He then re-estimates FGT's regressions. The coding change reverses the estimated relationship between negative equity and mobility. The new estimates show that negative equity raises the probability of moving by 10 to 18 percent, relative to the overall probability of moving in the AHS data. This of course is in marked contrast to FGT's results, where negative equity was found to significantly decrease the probability of moving.

What does theory tell us?
When thinking about what economic theory might say about the relationship between negative equity and mobility, it is important to distinguish how equity might affect selling versus how equity might affect moving. FGT write that their results suggest a role for what behavioral economists call "loss aversion." In this context, loss aversion can occur when owners are reluctant to turn paper losses into real ones by selling a home that has fallen in price. But, as Schulhofer-Wohl's analysis makes clear, it is possible and even common for households to move to different houses without selling their old ones. That means that loss aversion potentially affects the probability of selling a home without affecting the probability of moving.

Of course, while moving and selling are theoretically distinct, they often occur together in practice. One reason for the tight relationship between moving and selling involves liquidity constraints. Even short-distance moves entail nontrivial transaction costs, so households that do not have liquid wealth may not be able to move without selling their home. As a result, to the extent that negative equity decreases the probability of selling (via loss aversion), it may also decrease the probability of moving.

Besides loss aversion, there are at least two other channels through which liquidity constraints are relevant for the way that negative equity affects homeowner mobility. By definition, underwater households cannot retire their mortgages by selling their houses. Liquidity-constrained households that are also under water do not have the cash to make up the difference between the outstanding mortgage balance and sale price. As a result, negative equity could reduce selling (and, by extension, moving). On the other hand, liquidity-constrained households are more likely to simply default on their mortgages. Thus, negative equity might increase the probability of moving, though the moves that it facilitates are accompanied by foreclosures and not sales. Note that this "default channel" between negative equity and mobility depends importantly on expectations of future housing prices. Negative-equity households who do not think housing prices will rise any time soon are more likely to default on their mortgages, and thus move, than households who think that higher prices and restored housing equity are just around the corner.

The offsetting implications of liquidity constraints on mobility mean that theory doesn't provide a clean prediction for how negative equity should affect mobility. The question boils down to which implication is dominant in the data. The findings from the Schulhofer-Wohl paper suggest that the default channel may be relatively large, so concern about negative equity impeding homeowner mobility may be overblown.

Are these studies relevant to the current environment?
The sample period for both papers we have discussed ended in 2005. While we certainly believe that the issue addressed by both papers is very important, and that the Schulhofer-Wohl analysis corrects an important omission in the FGT study, we would offer a cautionary note to those who would extrapolate the findings of these studies to the current environment. The period 1985–2005 was a boom time in housing markets for most areas of the country. One way to see this is by noting the low number of negative equity observations in both the FGT and Schulhofer-Wohl papers. The majority of negative equity observations in the AHS data is likely from only a couple of areas in the country and from a narrow time period (most likely from the East and West coasts in the late 1980s and early 1990s). These places and time periods may be unrepresentative of the average negative-equity owner today.

Even more importantly, there were very few foreclosures from 1985 to 2005 relative to the past several years. This paucity of foreclosures was probably due not only to the low number of negative-equity households, but also to the low probability of foreclosure conditional on having negative equity. Recall that if housing prices are generally rising, households with negative equity will try hard to hang on to their homes and reap the benefits of future price appreciation, even if they are liquidity-constrained. It's probably safe to say that price expectations are lower today than they were in 1985–2005. Because low price expectations increase defaults, and because defaults and foreclosures increase the mobility of negative-equity owners through the default channel, it might be the case that the current effect of negative-equity on mobility is not only positive, but also even larger than the positive estimates in Schulhofer-Wohl's paper.

Photo of Kris GerardiKris Gerardi
Research economist and assistant policy adviser at the Federal Reserve Bank of Atlanta

1 This coding choice is not divulged in the FGT paper. The authors confirmed in private correspondence that it was a conscious decision to omit these categories and not a coding error, and that they are currently working on a revision of their original work that will address this issue.

March 9, 2011

The seductive but flawed logic of principal reduction

The idea that a program to reduce principal balances on mortgage loans will cure the nation’s housing ills at little or no cost has been kicking around since the very early stages of the foreclosure crisis and refuses to die. If news stories are true, the administration, in conjunction with the state attorneys general, will soon announce that lenders have agreed to write down borrower principal balances by a grand total of $20–$25 billion as part of a deal to address serious procedural problems in foreclosure filings. Policy wonks and housing experts will greet this announcement with glee, saying that policymakers have ignored principal reduction for too long but have seen the light and are finally going to cure the epidemic of foreclosures that has gripped the country since 2007. Are the wonks right? In short: we think not.

Why do so many wonks love principal reduction? Because they think principal reduction prevents foreclosures at no cost to anyone—not taxpayers, not banks, not shareholders, not borrowers. It is the quintessential win-win or even win-win-win solution. The logic of principal reduction is that in a foreclosure, a lender recovers at most the value of the house in question and typically far less. This is because of the protracted foreclosure process during which the house deteriorates and the lender collects no interest but has to pay lawyers and other staff to navigate 50 different byzantine state bureaucracies to get a clean title to the house, which it then has to sell in an extremely weak market. In contrast, reducing the principal balance to equal the value of the house guarantees the lender at least the value of the house because the borrower now has positive equity and research shows that borrowers with positive equity don’t default. To put numbers on this story, suppose the borrower owes $150,000 on a $100,000 house. If the lender forecloses, let's assume it collects, after paying the lawyers and the damage on the house, etc., $50,000. However, if it writes principal down to $95,000, it will collect $95,000 because the borrower now has positive equity and won't default on the mortgage. Lenders could reduce principal and increase profits!

The problem with the principal reduction argument is that it hinges on a crucial assumption: that all borrowers with negative equity will default on their mortgages. To understand why this assumption is crucial to the argument, suppose there are two borrowers who owe $150,000 but one prefers not to default (perhaps because she has a particularly strong preference for her current home, or because she does not want to destroy her

credit, or because she thinks there's a chance that house prices will recover) and eventually repays the whole amount while the other defaults. If the lender writes down both loans, it will collect $190,000 ($95,000 from each borrower). If the lender does nothing, it will eventually foreclose on one and collect $50,000, but it will recover the full $150,000 from the other borrower, thus collecting $200,000 overall. Hence, in this simple example, the lender will obtain more money by choosing to forgo principal reduction.

The obvious response is that the optimal policy should be to offer principal reduction to one borrower and not the other. However, this logic presumes that the lender can perfectly identify the borrower who will pay and the borrower who won't. Given that there is a $55,000 principal reduction at stake here, the borrower who intends to repay has a strong incentive to make him- or herself look like the borrower who won't!

This is an oft-encountered problem in the arena of public policy. Planners often have a preventative remedy that they have to implement before they know who will actually need the assistance. This inability to identify the individuals in need always raises the cost of the remedy, sometimes dramatically so. A nice illustration of this problem can be seen in the National Highway Traffic Safety Administration's (NHTSA) proposed regulation to require all cars to have backup cameras to prevent drivers from running over people when they drive in reverse. Hi-tech electronics mean that such cameras cost comparatively little: $159 to $203 for cars without a pre-existing navigation screen, and $53 to $88 for cars with a screen, according to the NHTSA. $200 seems like an awfully small price to pay to prevent gruesome accidents that are often fatal and typically involve small children and senior citizens. But the NHTSA says that the cameras are actually extremely expensive, and arguably prohibitively so. What gives? How can $200 be considered a lot of money in this context? The problem is that backup fatalities are extremely rare, something on the order of 300 per year, so the vast majority of backup cameras never prevent a fatality. To assess the true cost, one has to take into account the fact that for every one camera that prevents a fatality, hundreds of thousands will not. Done right, the NHTSA estimates the cost of the cameras between $11.3 and $72.2 million per life saved.

Some background
The idea of principal reduction starts with a correct premise: borrowers with positive equity—that is, houses worth more than the unpaid principal balance on their mortgages—rarely ever lose their homes to foreclosure. In the event of an unexpected problem (like an unemployment spell) that makes the mortgage unaffordable, borrowers with positive equity can profitably sell their house rather than default. The reason that foreclosures are rare in normal times is that house prices usually increase over time (inflation alone keeps them growing even if they are flat in real terms) so almost everyone has positive equity. What happened in 2006 is that house prices collapsed and millions of homeowners found themselves with negative equity. Many who got sick or lost their jobs were thus unable to sell profitably.

With this idea in mind, it then follows that if we could somehow get everyone back into positive-equity territory, then we could end the foreclosure crisis. To do that, we either need to inflate house prices, which is difficult to do and probably a bad idea anyway, or reduce the principal mortgage balances for negative-equity borrowers. So we have a cure for the foreclosure crisis: if we can get lenders to write down principal to give all Americans positive equity in their homes, the housing crisis would be over. Of course, the question becomes, who will pay? Estimates suggest that borrowers with negative equity owe almost a trillion dollars more than their homes are worth, and a trillion dollars, even now, is real money. The principal reduction idea might stop here—an effective but unaffordable plan—but people then realized that counting all the balance reduction as a cost was wrong. Furthermore, in fact, not only was the cost far less than a trillion dollars, but, as we noted above, many principal reduction proponents argue that it might not cost anything at all.

The logic that principal reduction can prevent foreclosures at no cost is compelling and seductive, and proposals to encourage principal reduction were common early in the foreclosure crisis. In a March 2008 speech, one of our bosses, Eric Rosengren, noted that "shared appreciation" arrangements had been offered as a way to reduce foreclosures; these arrangements had the lender reduce principal in return for a portion of future price gains realized on the house. In July 2008, Congress passed the Housing and Economic Recovery Act of 2008, which created Hope for Homeowners, a program that offered government support for new loans to borrowers if the lender was willing to write down principal.

While we were initially supportive of principal-reduction plans, we began to have doubts over the course of 2008. Our reasons were twofold. First, we could find no evidence that any lender was actually reducing principal. Commentators blamed the lack of reductions on legal issues related to mortgage securitization, but we became skeptical of this argument, because the incidence of principal reduction was so low that it was clear that securitization alone could not be the only problem or even a major one, (Subsequent research has shown this to be largely right: the effect of securitization on renegotiation was between nil and small in this crisis, and lenders did not reduce principal much even during the Depression, when securitization did not exist.) And the second issue, of course, was our realization of the logical flaw described above.

Negative equity and foreclosure
But aren't we being pessimistic here? Aren’t we ignoring research that shows that negative equity is the best predictor of foreclosure? No, we aren't. On the contrary, we have authored some of that research and have long argued for the central importance of negative equity in forecasting foreclosures. But what research shows is not that all or most people with negative equity will lose their homes but rather that while people with negative equity are much more likely to lose their homes, most eventually pay off their mortgages. The relationship of negative equity to foreclosure is akin to that of cholesterol and heart attacks: high cholesterol dramatically increases the odds of a heart attack, but the vast majority of people with high cholesterol do not have heart attacks any time in the near or even not-so-near future.

To be sure, there are some mortgages out there with very high foreclosure likelihood: loans made to borrowers with problematic credit and no equity to begin with, located in places where prices have fallen 60 percent or more. However, such loans are quite rare now—most of those defaulted soon after prices started to fall in 2007—and make up a small fraction of the pool of troubled loans currently at risk. To add to the problem, the principal reductions required to give such borrowers positive equity are so large that the $20–25 billion figure discussed for the new program would prevent at most tens of thousands of foreclosures and make only a small dent in the national problem.

Millions of borrowers with negative equity will default, but there are many millions more who will continue to make payments on their mortgages, behavior that is not, contrary to popular belief, a violation of economic theory. Economic theory only says that borrowers with positive equity won’t default (read it carefully). It is logically false to infer from this prediction that all borrowers with negative equity will default. "A implies B" does not mean that "not A" implies "not B," as any high school math student can explain. And in fact, standard models show that the optimal default threshold occurs at a price level below and often significantly below the unpaid principal balance on the mortgage.

The problem of asymmetric information
Ultimately the reason principal reduction doesn't work is what economists call asymmetric information: only the borrowers have all the information about whether they really can or want to repay their mortgages, information that lenders don’t have access to. If lenders weren't faced with this asymmetric information problem—if they really knew exactly who was going to default and who wasn't—all foreclosures could be profitably prevented using principal reduction. In that sense, foreclosure is always inefficient—with perfect information, we could make everyone better off. But that sort of inefficiency is exactly what theory predicts with asymmetric information.

And, in all this discussion, we have ignored the fact that borrowers can often control the variables that lenders use to try to narrow down the pool of borrowers that will likely default. For example, most of the current mortgage modification programs (like the Home Affordable Modification Program, or HAMP) require borrowers to have missed a certain number of mortgage payments (usually two) in order to qualify. This is a reasonable requirement since we would like to focus assistance on troubled borrowers need help. But it is quite easy to purposefully miss a couple of mortgage payments, and it might be a very desirable thing to do if it means qualifying for a generous concession from the lender such as a reduction in the principal balance of the mortgage.

Economists are usually ridiculed for spinning theories based on unrealistic assumptions about the world, but in this case, it is the economists (us) who are trying to be realistic. The argument for principal reduction depends on superhuman levels of foresight among lenders as well as honest behavior by the borrowers who are not in need of assistance. Thus far, the minimal success of broad-based modification programs like HAMP should make us think twice about the validity of these assumptions. There are likely good reasons for the lack of principal reduction efforts on the part of lenders thus far in this crisis that are related to the above discussion, so the claim that such efforts constitute a win-win solution should, at the very least, be met with a healthy dose of skepticism by policymakers.

Photo of Chris FooteChris Foote
Senior economist and policy adviser at the Boston Fed

Photo of Kris GerardiKris Gerardi
Research economist and assistant policy adviser at the Federal Reserve Bank of Atlanta

Photo of Paul WillenPaul Willen
Research economist and policy adviser at the Boston Fed

March 31, 2010

Anti-foreclosure policy and aggregate house price indexes

A new paper by researchers at the New York Fed and New York University argues that the Federal Housing Authority (FHA), the government's insurer of relatively high-risk loans, is seriously understating the amount of risk in its portfolio. The paper makes a number of different points, but we want to comment on one claim in particular that has policy relevance beyond the issue of FHA risk. In fact, if this claim is correct, then any policy designed to reduce foreclosures by eliminating negative home equity could face significant problems when put into effect.

Repeat sales indexes a poor predictor of individual home price
The specific issue we want to address is how well an aggregate house price index can predict the price of an individual home. A number of aggregate indexes measure average house prices for a particular area, from the national level to the ZIP-code level. Often, these indexes are based on repeat sales, meaning that they combine the price changes of individual homes over time. If a house sold for $200,000 in 1997 and $220,000 in 2001, this repeat sale provides a data point indicating that house prices rose by 10 percent from 1997 to 2001. It is true that the 2001 buyer might have gotten a great deal in that the house really should have sold for more than $220,000 at the second sale. However, the assumption is that the influence of good and bad deals washes out when data from many repeat sales are aggregated together. If they do, then researchers can infer the average, overall path of house prices.

The problem occurs, the authors of the paper say, when one uses the resulting aggregate index to predict the price of an individual home. Consider someone who purchased a home for $200,000 in 2007. Now assume that over the next two years the aggregate house price index for that particular area declined by 10 percent. The authors point out that the decline in the index does not necessarily mean that this particular homeowner would have sold the house for $180,000 in 2009. The owner may have taken extremely poor care of the house, or a beautiful park that was across the street from the house at the time of purchase may have become a strip mall. In either case, the homeowner was likely to have sold for less than $180,000. On the other hand, the homeowner may have made some improvements to the home that would have resulted in a sale of more than $180,000.

Research paper provides careful analysis of valuation errors in aggregate indexes
Potential problems with repeat-sales indexes were well known before the FHA paper was written. What the new paper contributes is a careful analysis of how large these so-called valuation errors can be and how they might relate to the probability of having negative equity. Using residential sales from Los Angeles County, the authors compare the actual sales prices of houses with predictions generated by different aggregate price indexes. The authors make two important findings.

First, the repeat-sales indexes are often biased, in the sense that the mean of the predictions does not match the mean of the recorded prices. For 2008 and 2009, repeat-sales indexes tended to overpredict house prices by 7 to 18 percent. In 2007, the indexes underpredicted house prices by about 4 percent. Second, dispersion in individual valuation errors is large—the standard deviation of valuation errors is about 20 to 25 percent, depending on the aggregate index used. Putting these two facts together gives a clear message: Using standard methods, it is difficult to predict what any individual house will sell for at any particular time.

Valuation errors undermine mortgage balance reduction policies
On a general level, this observation is not an indictment of the FHA, since a lot of other people also use aggregate indexes to infer prices of individual homes—including us. Moreover, without knowing the ins and outs of the FHA's default-prediction model, it is hard to know the quantitative importance of valuation errors in the calculation of FHA risk. But moving beyond this issue, it is not hard to see how large valuation errors could undermine the effectiveness of a policy that attempted to ease foreclosures by reducing mortgage balances for individual negative-equity homeowners. As we have blogged recently, some observers have claimed that many, if not most, foreclosures occur because owners with large amounts of negative equity simply walk away from their homes. The ostensible policy implication is to reduce these homeowners' mortgage balances to give them more of an incentive to stay.

If valuation errors are large, however, it is very difficult to know who has severe negative equity and who doesn't. This problem undermines the effectiveness of balance-reduction policies. Effective policymakers must know how to price individual homes to assess the depth of negative equity for those homes. Consider two homes that, according to an aggregate price index, have 30 percent negative equity. That amount may or may not be severe enough to get an owner thinking about walking away. If it is, then an appropriate policy might reduce both homes' mortgage balances by 20 percent, thereby reducing the negative equity to about 10 percent. (Leaving a little bit of negative equity is probably a good idea in practice because it may prevent homeowners from selling the moment that a balance reduction is made.)

Effective foreclosure prevention would consider both job loss and negative equity
If in reality one of these homes actually has 50 percent negative equity and the other has 10 percent negative equity, then the balance-reduction policy is likely to prevent no foreclosures. The owner with 50 percent negative equity remains underwater, to the tune of 30 percent, so is probably still thinking about walking away—according to the theory of default that motivated the balance-reduction policy in the first place. On the other hand, the owner with 10 percent negative equity was not going to walk, unless perhaps a job loss went along with the negative equity. But if the combination of job loss and negative equity is the real problem in the housing market rather than severe amounts of negative equity alone then we can devise much more cost-effective policies to reduce foreclosures than large-scale balance reductions.

The authors of the paper do not discuss balance reductions. However, in other papers, they argue that anti-foreclosure policy should consider balance reductions. We believe that the valuation-error results uncovered in the FHA paper indicate that balance-reduction policies face substantial hurdles in actual practice.

By Chris Foote, senior economist and policy adviser at the Boston Fed (with Atlanta Fed economist Kris Gerardi and Boston Fed economist Paul Willen)

March 2, 2010

Should modifications 're-equify' borrowers? A look at the data

A number of recent commentators have called for a big change in government policy on mortgage modifications. Currently, the government's Home Affordable Modification Program (HAMP) pays cash incentives to servicers who reduce monthly mortgage payments to no more than 31 percent of the borrower's income. Most of the time, this reduction is accomplished by reducing the interest rate or by extending the loan term for up to 40 years. Modifications that forgive loan principal are rare.

And therein lies the problem, according to HAMP critics, who point to the strong empirical relationship between negative home equity and default. On the national level, the U.S. foreclosure rate started rising in 2006, the same time that house prices began to fall and negative equity began to emerge. Also, in loan-level data, borrowers who are "underwater" on their mortgages default far more often than owners with positive home equity. Many of HAMP's critics argue that mortgage modifications will not work unless they reduce outstanding principal balances on mortgages so that positive equity is restored. Yet a closer look at the data shows that a "re-equification" policy implemented through large-scale principal reductions may not work as advertised.

Are won't-pay borrowers really behind the high foreclosure rate?
If negative equity drives default, then why shouldn't modifications start by reducing mortgage balances? The reason is that underwater borrowers default for one of two reasons—either they can't make their payments or they won't make their payments. (You can read more about this here.) Proponents of balance reductions seem to think that foreclosures are driven mostly by won't-pay borrowers, who would rather "walk away" from their underwater homes than continue paying. But these proponents provide little hard data about how prevalent won't-pay defaults really are.

Of course, walk-away borrowers do exist and are sometimes profiled in newspaper accounts (like this one). But these accounts often involve borrowers at the extreme end of the negative-equity spectrum, where the house is worth only 50–70 percent of the mortgage balance. For owners with more moderate levels of negative equity, economic theory implies that staying current on the mortgage is usually the best policy. This theory is true even for cold-hearted homeowners who don't care about offending their lenders, damaging their credit scores, incurring any social stigma associated with default, or paying the deficiency judgments that can sometimes be levied against walk-away owners. The reason that moderately underwater homeowners should continue paying is that prices might rise and positive equity might be restored, so long as the current price is not too far below the mortgage balance. The benefit of staying in the house today is enhanced by the right to default in the future, if house prices stay low and equity remains negative.

Principal reductions may not keep can’t-pay borrowers at home
For every homeowner who defaults because they won't pay on their mortgage, there are others who default because they can't pay. Among the can't-pay group are the many borrowers who have lost their jobs. Negative equity matters for this group because it limits their options when their economic situations become dire. Before the recent fall in house prices, homeowners who lost their jobs were likely to have positive equity in their homes. This equity allowed displaced workers to sell their homes and pay off their mortgages if they needed to; cash-out refinancing may also have been an option. But underwater owners cannot sell their homes for enough to pay off their mortgages, nor can they refinance. Foreclosures are therefore likely for can't-pay borrowers with negative equity, even if they want to stay in their homes.

Unfortunately, principal reductions will probably not help can't-pay borrowers retain their homes. Consider a borrower who is 10 percent underwater and who recently lost her job. A reduction of, say, 20 percent would restore positive equity for this borrower. But it would lower her monthly payment by only about 20 percent—too little to make a difference for someone with drastically reduced income. Consequently, if this borrower gets a 20 percent principal reduction, she will probably sell her house. Anti-foreclosure policy will not keep her in her home, which was the justification for the policy in the first place.

Some might argue that a principal reduction helps can't-pay borrowers who live in a state that allows lenders to seek deficiency judgments. Because the reduction would give these borrowers positive equity, they would have no deficiency when paying off the loan. But the can't-pay borrowers probably did not have the money to pay a deficiency judgment anyway, so the reduction does not provide much of benefit. The balance reduction would help the lender, as long as the reduction is paid for by the taxpayers. If the reduction allows a sale to take place, rather than a foreclosure, it may also reduce the "deadweight" costs of foreclosure (for example, damage to the house that sometimes occurs when a house is foreclosed). For the most part, though, if can't-pay borrowers are the problem, then a policy of subsidized balance reductions would simply reshuffle losses generated by the housing bust to different parties.

Area-level data, not national data, measure can’t-pay defaults more accurately
Ideally, mortgage researchers would inform policymakers about the exact size of the can't-pay group. This is difficult to do, because borrower-level data on both unemployment and delinquency experiences do not exist. That means that we cannot measure the effect of an individual's unemployment spell on the probability of delinquency, controlling for other factors (like credit score). The best that researchers can do is match area-level unemployment rates with borrower-level mortgage data, and then see whether delinquencies rise when local unemployment goes up. According to some of our research, they do. This Congressional testimony from Laurie Goodman, a respected mortgage researcher and a proponent of balance reductions, cites some of her work that also suggests a correlation between area-level unemployment and mortgage delinquency.

While using area-level unemployment rates isn't a perfect way to measure can't-pay defaults, it is far more helpful than correlating the national unemployment rate with the national delinquency rate, which is sometimes done by proponents of balance reductions. The U.S. unemployment rate started increasing rapidly in 2008. But mortgage delinquencies had already started rising for the riskiest mortgages (like subprime) during the previous year, when house prices began their descent. Proponents of balance reductions interpret this timing pattern as evidence that unemployment is a less-important determinant of foreclosures. Policy should therefore focus on restoring equity to prevent the won't-pays from walking away.

But the fact that national delinquency rates rose before the unemployment rate did is not conclusive. Because of the large amount of job creation and destruction that always takes place, can't-pay borrowers can still exist even when the aggregate unemployment rate is low and stable. Specifically, the Business Employment Dynamics program of the Bureau of Labor Statistics indicates that gross job losses at private American firms totaled about 12.6 million positions from March 2007 to March 2008. Positions that were eliminated via involuntary layoffs were likely to have led to a lot of can't-pay foreclosures for job losers with negative equity. But this large amount of job destruction did not cause the aggregate unemployment rate to rise. Over the same period, private-sector gross job creation totaled 12.7 million jobs, so that the net number of jobs in the economy rose by about 100,000. Correlating national unemployment and delinquency rates masks the massive amount of job churning that takes place at the level of individual workers, where default decisions are made.

Foreclosure-reduction assistance is necessary but should be temporary
We have been interested in the efficacy of mortgage modifications for some time; our finding that less than 10 percent of underwater borrowers lost their homes during the early-1990s Massachusetts housing bust is often interpreted (correctly, we think) as evidence that walk-away foreclosures are not the lion's share of today's problem. Moreover, given our research findings, my co-bloggers and I support a foreclosure-reduction policy that would offer significant but temporary help to unemployed borrowers. But we also think that disinterested parties should come away from this issue with the same verdict that we do. There have been news accounts about won't-pay borrowers walking away from their homes for at least two years. Before policy encourages large-scale reductions in mortgage balances in modification programs, we believe more hard data is needed that show that won't-pay borrowers are quantitatively important.

By Chris Foote, senior economist and policy adviser at the Boston Fed (with Atlanta Fed economist Kris Gerardi and Boston Fed economist Paul Willen)