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Research & the Economy


Atlanta Fed Research Examines Drivers of Default

Image of a money cigaretteAs policymakers continue to grapple with the consequences of the foreclosure crisis, one critical question remains—what drives homeowners to default on their mortgages?

In "Unemployment, Negative Equity, and Strategic Default," Atlanta Fed financial economist and associate policy advisor Kristopher Gerardi seeks to answer this question. He coauthored the working paper with Kyle F. Herkenhoff and Lee Ohanian, both of the University of California–Los Angeles, and Paul S. Willen of the Boston Fed.

Employment, net wealth key determinants
In contrast to virtually all prior studies, this one used direct data on individual employment. It found job loss to be one of the most important drivers of defaults. Indeed, holding all other factors constant, unemployment increases the probability of default by 8 to 13 percentage points, the authors write.

In addition, negative equity of 20 percent or more increases the probability of default by 5 to 18 percentage points. However, underwater borrowers are less likely to default if they also have more liquid assets on hand, such as money in a checking or savings account.

If factors such as job loss and negative equity alone can cause a homeowner to default, what happens when an individual is both jobless and underwater on their mortgage? When those two factors collide, the so-called "double trigger" effect raises the unconditional rate of default by about 11.5 percent "over and above either trigger on its own," the study found.

Strategic defaults "rare"
Reports of owners strategically defaulting on their mortgages have been common during the housing crisis. Strategic, or "ruthless," defaults occur when a homeowner defaults despite having sufficient liquid assets to make the mortgage payment. Only about 14 percent of defaulters in the study's main data set met those qualifications, which suggests that "strategic default is not a major factor in understanding recent mortgage default decisions, but rather that defaulters may have few options other than to default," the authors note. As a result, temporary mortgage modifications—one of the policies pursued throughout the crisis—may not be a good long-term solution. Instead, the authors conclude, policymakers should consider policies that boost employment and earnings as a way to stem the tide of defaults.

Want to learn more? Read the entire working paper.