Let's consider two scenarios. In scenario 1, the borrower loses his job but still has positive equity in his home. In this case, he may be unable to continue paying his mortgage, but he can preserve his equity (and his credit rating) simply by selling his home. Default is therefore unlikely.
In scenario 2, the borrower keeps his job but the market value of his home falls below the outstanding balance on his mortgage. In common parlance, the borrower is 'underwater' on his mortgage. If he falls far enough underwater, he may make a purely financial decision to walk away from his home, rather than continue paying his mortgage. Default therefore becomes increasingly likely as the value of the home falls, even though the borrower’s ability to service his mortgage remains unchanged.
The Great Recession has brought job losses as well as home price declines. To some extent, the two effects have fed on each other: Job losses have resulted in lower demand for housing, which has led to price declines; and price declines have resulted in lower housing construction, which has led to job losses. Nonetheless, the scenarios considered above suggest that an underwater borrower is a bigger default risk than a borrower who has simply lost his job. This is borne out by recent default activity in the Bay Area.
Consider the chart, below, which compares default rates for the first quarter of 2009 (vertical axis) to the percentage of mortgages that were underwater in November of 2008 (horizontal axis). Each dot represents one of the nine Bay Area counties.
The relationship between the two variables is clearly strong, and seems to indicate that being underwater is an excellent predictor of the likelihood that a borrower will default in the near term. (Note: Information on default activity was obtained from Dataquick. Information on underwater mortgages was obtained from Zillow, by way of the San Francisco Chronicle.)
Since I don’t have ongoing access to data about underwater mortgages, I thought it would be useful to create an alternative version of the chart above, using recent price declines as a proxy for the percentage of mortgages that are underwater.
The vertical axis shows the Q1 2009 default rate for each county, as before. The horizontal axis shows a measure of the recent price change for each county. (Using the average price for the three-year period from July, 2005 to June, 2008 as a base, I calculated the percentage change in price through the end of 2008. I reversed the axis to facilitate comparison with the first chart, above.)
The relationship isn’t as strong as before, but still seems compelling. In a future blog posting, I’ll develop a better proxy for the percentage of mortgages that are underwater. For now, I’ll point out that prices have continued to fall in every county except Marin (where they’ve risen by a meager 3% since the end of the year) and San Francisco (where they’ve remained flat). The wave of foreclosures in the Bay Area therefore seems likely to continue building for some time to come.
