Who Defaults?
* Posted by ryan on May 6th, 2009 filed in Economics
Atrios has been sounding the alarm over a coming “second wave” of foreclosures, generated by the recasting of Option ARMs. Now, it’s true that these recasts are a different animal from your basic interest rate reset on a fully amortized ARM, but I think that the trajectory of housing defaults to date indicate that this might not be as big a problem as Duncan thinks (or not a problem in the way Duncan imagines).
Since the housing bust began, people have approached the problem of rising defaults as being principally about payment shocks, but that’s not really borne out by the data. In his long and fascinating look at the unfolding of the financial crisis, Phillip Swagel discusses how the Bush Treasury’s initial approach to the foreclosure crisis focused on interest rate resets, but he says they quickly discovered that wasn’t the main problem. He notes that if you chart 2/28 and 3/27 mortgage defaults over time, you don’t see the kink at the 24 or 36 month mark you’d expect if the reset was doing most of the work in generating foreclosures. What they found was that defaults were happening surprisingly quickly — basically, underwriting standards were so terrible that borrowers couldn’t even afford the initial payment.
As the bust has proceeded, by contrast, defaults have mainly resulted from the combination of negative equity and some kind of income shock — job loss, death or illness, divorce, and similar. A recent paper from economists at the Boston Fed found evidence along these lines and concluded that policymakers would have better luck reducing defaults through, say, fully funding unemployment insurance programs than through trying to reduce payments.
The logic behind these findings is that you have a lot of homeowners who are just a little underwater, and they’re mostly going to keep paying their mortgages (assuming they don’t lose their jobs) because they don’t want to ruin their credit and there’s a decent chance that within a few years they’ll be back in positive equity territory. You then have a lot of really underwater homeowners. You can reduce their payment by 50% and it still wouldn’t make sense for them to stick around. You have to figure anyone who’s been in a negative amortization situation in recent years is seriously underwater, and I just don’t see that a payment recast is going to have much of an effect on the decision to stay or walk away.
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