Strategic Defaults

 By   Kyle Herkenhoff  Researcher, UCLA Ziman Center for Real Estate
Were defaults driven purely by negative equity during the 2007-
2009 recession? Or were households defaulting because of
liquidity constraints (a lack of cash-on-hand) stemming from job
loss?
Even several years after the National Bureau of Economic
Research (NBER) marked the trough of the recession (June 2009), there is still considerable debate about
the causes of default. Using a new data supplement from the Panel Study of Income Dynamics (PSID), my
coauthors (Kris Gerardi, Lee Ohanian, and Paul Willen) and I found that job loss is the main “single trigger”
determinant of default.
These findings have important policy implications. They suggest that temporary mortgage modifications do not
provide a long-term solution to default. Rather, the key to stemming mortgage defaults is developing policies
that promote re-employment and higher earnings, such as payroll tax cuts.
More specifically, we found that job loss increases the probability of default between 5 to 13 percentage points.
Severe negative equity (-20% or more) also increases the probability of default by 5 to 18 percentage points.
But the impact of severe negative equity on default drops significantly in magnitude when liquid asset positions
are taken into account. Furthermore, we found evidence for the “double trigger” event of job loss and negative
equity, as well as job loss and severe negative equity. Specifically, we found that the joint occurrence of both
job loss and negative equity raises the unconditional default rate by 11.3% over and above either trigger on its
own.
A striking finding of the empirical analysis is on the frequency of strategic default, which is typically defined as
default by borrowers who have sufficient resources to make the mortgage payment. As a suggestive measure,
we looked at whether or not defaulting households with negative equity have enough liquid assets to make
their mortgage payment
We found that strategic default is rare in the PSID data. In particular, only 13.9 percent of defaulters in the
PSID had sufficient liquid assets to make a mortgage payment. We confirmed the rarity of strategic default
using data from the SCF which shows that only 6 percent of defaulters have sufficient liquid assets to make
one mortgage payment. These findings suggest 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.