USA: The Depth Of Negative Equity And Mortgage Default Decisions

Introduction

The paper “The Depth of Negative Equity and Mortgage Default Decisions” by Neil Bhutta, Jane Dokko, and Hui Shan explores a fundamental question in housing finance: when do underwater homeowners choose to default on their mortgages, even when they could afford to pay? Using rich data for non-prime borrowers in four U.S. states (Arizona, California, Florida, Nevada), the authors analyze how deeply negative equity influences Mortgage Default Decisions, separating defaults due to income shocks from those driven primarily by negative home equity. Their findings shed light on the strategic behavior behind mortgage default decisions, revealing that many borrowers delay walking away until their equity is deeply in the red. A central question in the literature on mortgage default is at what point underwater homeowners walk away from their homes even if they can afford to pay. We study borrowers from Arizona, California, Florida, and Nevada who purchased homes in 2006 using non-prime mortgages with 100 percent financing. Almost 80 percent of these borrowers default by the end of the observation period in September 2009. After distinguishing between defaults induced by job losses and other income shocks from those induced purely by negative equity, we find that the median borrower does not strategically default until equity falls to -62 percent of their home’s value. This result suggests that borrowers face high default and transaction costs. Our estimates show that about 80 percent of defaults in our sample are the result of income shocks combined with negative equity. However, when equity falls below -50 percent, half of the defaults are driven purely by negative equity. Therefore, our findings lend support to both the “double-trigger” theory of default and the view that mortgage borrowers exercise the implicit put option when it is in their interest. House prices in the U.S. plummeted between 2006 and 2009, and millions of homeowners, owing more on their mortgages than current market value, found themselves “underwater.” While there has been some anecdotal evidence of homeowners seemingly choosing to walk away from their homes when they owe 20 or 30 percent more than the value of their houses, there has been scant academic research about how systematic this type of behavior is among underwater households or on the level of negative equity at which many homeowners decide to walk away.1 Focusing on borrowers from Arizona, California, Florida, and Nevada who purchased homes in 2006 with non-prime mortgages and 100 percent financing, we bring more systematic evidence to this issue.

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1. Motivation and Research Question

The study centers around homeowner incentives in the wake of the 2006–2009 housing bust, when millions of U.S. borrowers became “underwater”—owing more than the market value of their properties. A core issue is whether and when these borrowers decide to stop making payments, a behavior often framed as strategic default. The authors examine Mortgage Default Decisions by focusing on non-prime mortgages originated in 2006 with full (100%) financing, allowing them to closely observe the evolution of equity and how it affects default behavior. Federal Reserve+2Federal Reserve+2

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2. Data and Sample

• The dataset comes from LoanPerformance (First American CoreLogic), capturing detailed monthly performance for subprime and alt-A mortgage loans. Federal Reserve+1

• The sample includes loans from four states: Arizona, California, Florida, and Nevada, which experienced severe house price declines during the crisis. Federal Reserve

• These mortgages had 100% loan-to-value (LTV) at origination, meaning borrowers had no equity when they bought. Federal Reserve

• The authors merge loan-level data with local economic variables (county unemployment rates, ZIP‑level credit card delinquency), and housing price indexes to construct monthly equity measures. Federal Reserve

• At termination (either default or end of observation), the median borrower’s equity was about –24%, indicating they owed significantly more than the current house value on average. Federal Reserve+1

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3. Methodology: Estimating Mortgage Default Decisions

To understand Mortgage Default Decisions, the authors use a two-step estimation strategy:

1. Hazard model for non-equity-driven default:

   • First, they model the probability of default due to liquidity shocks (job loss, credit problems) while holding equity constant. Federal Reserve+1

   • This step isolates the portion of default risk that is not directly tied to negative equity, helping separate income-shock defaults from equity-driven defaults.

2. Maximum likelihood estimation (MLE) of “strategic default” costs:

   • Second, they infer what the cost of default (monetary + non-monetary costs) must be for Mortgage Default Decisions to occur at different levels of equity.

   • They estimate a distribution of “cost of default” (denoted as $TC$) across borrowers, using MLE to fit a gamma distribution to the inferred costs. Federal Reserve

   • This allows them to compute, for any equity level, the proportion of borrowers who would find default optimal, based purely on equity.

By combining these two steps, the authors can estimate how deeply negative equity must become before strategic default becomes a rational decision in Mortgage Default Decisions.

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4. Key Findings: Deep Negative Equity and Default

a. Depth of Negative Equity for Strategic Defaults

• The median borrower in their sample does not strategically default until their equity falls to –62% of the home’s value. Federal Reserve

• This is far more negative than anecdotal accounts that suggested many walk away when owing only 20–30% more than the home’s value. Federal Reserve+1

• These results imply very high costs to default: default isn't purely a financial arbitrage; non-monetary costs and future capital gains matter. Federal Reserve

b. Role of Income Shocks (Double‑Trigger Hypothesis)

• The authors find strong support for the double-trigger hypothesis: many defaults require two triggers — (1) deep negative equity, and (2) a liquidity shock (e.g., unemployment). Federal Reserve+1

• About 80% of defaults in their sample are associated with both income shocks and negative equity. Federal Reserve

• However, when equity falls below –50%, about half of the defaults appear to be driven purely by negative equity, i.e., strategic default in the absence of a liquidity shock. Federal Reserve

c. Heterogeneity in Mortgage Default Decisions

• There is substantial variation in the estimated cost of default across borrowers: the 25th percentile cost is about 33% of house value, the 75th percentile is 103%, showing large behavioral and state‑specific differences. Federal Reserve

• Borrowers in Florida and Nevada (recourse states where lenders can sue for deficiency judgments) face higher estimated default costs than those in Arizona or California (which have non-recourse laws for primary residences). Federal Reserve

• Mortgage type also matters: borrowers with short-term hybrid adjustable-rate mortgages (e.g., “2/28s” or “3/27s”) show lower implied costs of default than fixed-rate borrowers, indicating more “strategic behavior” in that subgroup. Federal Reserve+1

• Borrowers who fully documented incomes/assets face different Mortgage Default Decisions than those with limited documentation — documented borrowers often show higher cost-of-default estimates. Acash

• Payment history matters too: borrowers who missed at least one payment but subsequently caught up tend to have higher default costs, suggesting they are more emotionally or financially committed to staying in the home. Acash

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5. Interpretation: Why Deep Negative Equity Matters for Mortgage Default Decisions

The authors argue that their findings challenge simplistic theoretical models of default. Traditional models, like fully rational, fully informed borrowers, often assume that default will be triggered at mild negative equity. But the Mortgage Default Decisions observed empirically show otherwise:

• Borrowers in the studied sample did not default rashly when underwater; they waited until their debt was massively higher than their home’s value. Federal Reserve

• This suggests large implicit costs of default: not just financial costs (legal, relocation, deficiency), but non‑monetary costs like stigma, loss of future gains, or emotional attachment. Federal Reserve+1

• The presence of a double-trigger for default underscores that Mortgage Default Decisions are not driven purely by equity. Liquidity risks play a critical role. When negative equity is shallow, borrowers tend not to default unless combined with a job loss or other income shock. Federal Reserve

• Yet, when equity is very negative (below –50%), many choose to default even without liquidity shocks—suggesting they are exercising an implicit put option: treating the mortgage like a call option in reverse, walking away when the house is too underwater. Federal Reserve

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6. Policy and Structural Implications

Based on their analysis of Mortgage Default Decisions, the authors draw several policy-relevant implications:

1. Costly default: Because Mortgage Default Decisions require very negative equity to be triggered by itself, policies aimed at reducing negative equity (e.g., principal reduction, loan modifications) may strongly affect default behavior—but only for the most underwater owners.

2. Importance of liquidity support: Since many defaults occur only with the double-trigger (negative equity + income shock), safety nets like unemployment insurance, job stabilization policies, or mortgage forbearance may significantly reduce default rates.

3. Legal environment matters: The variation in Mortgage Default Decisions across recourse and non-recourse states suggests that the legal rights in mortgage contracts affect strategic default behavior. Non-recourse laws may lower the cost of walking away, impacting default decisions.

4. Heterogeneous responses: Because borrowers differ in documentation status, mortgage type, and payment history, a “one-size-fits-all” policy is unlikely to address the full spectrum of Mortgage Default Decisions. Tailored policies (modification terms, documentation requirements) may be more effective.

5. Behavioral considerations: Emotional, non-monetary factors seem important in Mortgage Default Decisions. Borrowers often pay a substantial “premium” (relative to market rent) to remain in their homes, even when underwater. That suggests models of default should account for behavioral and psychological costs, not just economic ones.

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7. Limitations and Directions for Future Research

The authors acknowledge some limitations in their study of Mortgage Default Decisions and propose future research directions:

• Their cost-of-default estimates reflect average behavior, but cannot precisely decompose all the non-monetary costs (stigma, emotional, expectations) shaping Mortgage Default Decisions. Understanding how much each factor contributes remains an open question.

• Their model does not fully capture borrower beliefs: some underwater borrowers may not believe their equity is as negative as modelled, or may anchor on original purchase price, altering Mortgage Default Decisions. Federal Reserve

• The analysis is limited to 2006-originated non-prime loans in four states; whether their Mortgage Default Decisions generalize to prime borrowers, other states, or later housing cycles is uncertain.

• Institutional and legal frameworks (local foreclosure delay policies, state deficiency law, stigma) may change over time; future research could explore how changing Mortgage Default Decisions evolve across policy regimes.

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8. Conclusion

In sum, the paper makes a powerful contribution to our understanding of Mortgage Default Decisions by showing that:

1. Strategic defaults tend to occur only when homeowners are very deeply underwater (median ~–62% equity), not just mildly underwater.

2. A large fraction of defaults are “double-triggered”: negative equity alone is not enough; income or liquidity shocks often are needed, especially at shallower negative equity.

3. There is substantial heterogeneity in default behavior based on mortgage type, legal environment, borrower documentation, and payment history—all influencing Mortgage Default Decisions.

4. Non-financial costs—such as stigma, lost future home value, and emotional attachment—play a central role in Mortgage Default Decisions and prevent many borrowers from defaulting early, even when underwater.

These findings suggest that any policy aimed at reducing foreclosures or designing mortgage relief must account not just for the financial mechanics of negative equity, but also for the behavioral, legal, and economic complexities underlying Mortgage Default Decisions.

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