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The real reason borrowers default

Posted by: Peter Coy on February 15, 2008

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.

Reader Comments

Brandon W

February 15, 2008 11:43 AM

An expected - but still interesting result - of all these foreclosures is the increase in apartment rentals. (See story)

Granted, this is in the Flint, MI area which has been hard hit, but I would expect we could see more of this nationwide in the next couple of years.

Jim D

February 15, 2008 12:22 PM

Isn't it more accurate to say that the banks instead suffered from a "failure of imagination" in that they didn't think that homes would fall in value by a significant amount?

Take that out of the equation, and what they did makes perfect sense, even if they thought that people would walk if their values fell too much - since it was never considered a significant possibility, it wasn't something they would need to worry about.

Of course, there's dozens of Bubble Blogs with thousands of readers that thought just that would happen, but hey, who reads blogs anyway, they're just filled with crackpots.

Thank you Ben Jones, for saving me from bankruptcy!


February 18, 2008 10:15 AM

What about the McMansion factor? Those huge houses not only lose value faster, they are more expensive to maintain. Friends and family were surprised when during my divorce, I turned down the 3,000 sqf house in a great neighborhood for a settlement. I knew what it cost to maintain that house. Energy costs, maintainance costs, etc. I opted for a smaller (1,700 sqf) more energy efficient house in a nice but transitional neighborhood.


February 20, 2008 9:47 PM

This is a result when people start to gamble with OPM (other people's money). What is the negative, to walk away with a bad credit report? I understand it's easy to get credit after bankruptcy so why not with just a foreclosure? Until lenders force home owners to put some of their skin in the game, and until the Feds start cracking down on mortgage fraud (how many investment homes are marked as primary residences?), this musical houses game with OPM will continue.

John Merzlock

February 22, 2008 5:02 PM

Like everything else, the pendulum has swung too far to the right. The lenders are over qualifying or denying loans to prospective home buyers. They have become too restrictive and reactive to the present market conditions. Also, lets tell the news media, that we are tired of them pounding this story into the ground. The lenders are the most gullible when it comes to the news.

Marcio - S. Florida

February 22, 2008 11:15 PM

I absolutely agree with Wes. Personal bankruptcy is no longer a problem in the U.S. Specially for people that had crummy credit to begin with.

Those people are fully adapted to a life of high-interest consumer loans and could not care less if they have a bankruptcy in their credit report.

The problem we face here is why they got a loan in the first place. The consequence should not matter. The reason why we have people who should have never qualified for a loan currently defaulting on a loan is what we should truly examine here.

Worldwide markets and the creation of pre-package, triple-AAA labeled, sub-prime securities satisfied a worldwide hunger for highly leveraged risky lending.

The problem we have found is that you cannot diversify risk in lending by using different sub-prime sources. Bad credit is bad credit, and people with bad credit usually behave similarly regardless of geographic location.

I am not calling for the tightening of standards because that would put honest people who had problems out of an opportunity to buy a home. However, these people who are entering loans with nothing down, should be thoroughly qualified to ensure their payment worthiness (not credit worthiness).

Homes are roofs over our head, so I don't feel the rules of traditional consumer credit apply here.


February 25, 2008 10:53 AM

YOu guys kill me the only people that is walking away from their homes is the subprime borrower who brought a house for more than they can aford. Every subprime borrower did not go after the big house and the great area. We went small town, less for the house big for the price. Area was not perfect but liveable

Marcio - S. Florida

February 26, 2008 8:07 PM

Understood Rose,

However, as you know, as loan is a financial instrument that requires monthly payments and even a subprime borrower is responsible for contracting and making those payments.

The fact that you are (or others) a subprime borrower should not give you a waiver on the basic principle of lending regardless of how much your borrowed.

Supposedly, you went small on a small town (as you stated). You bough a home for $100K and your payment now is around $800 including taxes and insurance.

If your loan started as an ARM at 1% with really low payments and now has reset to a $1000 payment. That are two guilty parties here.

1. You. Yep, you... you didn't get educated on home buying and should face the consequences of your poor decision.

2. The mortgage broker. Every broker has the fiduciary obligation of properly representing you as a lender. They offered a garbage loan to an unstable buyer, so they could get their commission.

Now, go get your finances in check and don't lose your home.



May 1, 2008 4:09 PM

What should we do, walk away or struggle to pay? We are not paying other bills to pay the mortgage and our house is upside down. Is it worth it to struggle to pay when our note has become more than what we bring home and our house is upside down?

Please advise without judgement.

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BusinessWeek editors Chris Palmeri, Prashant Gopal and Peter Coy chronicle the highs and lows of the housing and mortgage markets on their Hot Property blog. In print and online, the Hot Property team first wrote about the potential downside of lenders pushing riskier, "option ARM" mortgages and the rise in mortgage fraud back in 2005—well ahead of many other media outlets. In 2008, Hot Property bloggers finished #1 in a ranking of the world's top 100 "most powerful property people" by the British real estate website Global edge. Hot Property was named among the 25 most influential real estate blogs of 2007 by Inman News.

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