Is There a Puzzle in Underwater Mortgage Default? 
Economists have struggled to explain why homeowners with negative equity in their homes—homeowners who are underwater—might not default on their mortgages. In this paper, the authors argue that this “strategic default puzzle” arises not because households fail to act optimally with respect to their financial interests, but because economists historically have miscalibrated the relative payoffs of a borrower with negative equity staying in a home versus exiting into the rental market. A novel, detailed model of mortgage default that more accurately captures these tradeoffs resolves this puzzle.
Key Findings
- Whereas previous studies focus on “double trigger” models of mortgage default driven by negative equity and income declines, the results in this paper support a “triple trigger” model in which income declines, negative equity, and changes to the relative costs of owning versus renting together trigger default.
Implications
This paper’s findings suggest that historically, defaulting on a mortgage has been more costly than previously understood, and that households seldom benefit financially from default. The implication is that liquidity policies meant to prevent foreclosure likely will be welfare improving. These results thus offer a more realistic interpretation of the effects of policies such as the Home Affordable Modification Program that were implemented during the Great Recession to mitigate default. In addition, these findings strengthen the theoretical case for the effectiveness of cash-flow-based policies, such as mortgage forbearance, for reducing household default.
Abstract
A recurring question in the mortgage default literature is why underwater default is rare relative to model predictions. We find that one answer is miscalibration of flow payoffs. We build a novel, detailed quantitative model of mortgage default and find that realistic rent dynamics plus mild levels of default costs are sufficient to eliminate negative-equity strategic default. We present further empirical results supporting our model’s focus on flow payoffs. Our model addresses the underwater mortgage default puzzle, offers more realistic interpretations of policy consequences, and reinforces the theoretical effectiveness of cash-flow-based interventions.