How Rational Discrimination Affects Unemployment and Foreclosure Rates

Unemployment and foreclosure rates have skyrocketed over the last 1-2 years. The regions experiencing the most unemployment seem also to be the ones that have the highest foreclosure rates.

Both economic theory and data suggest that unemployment by itself cannot create much foreclosure. Negative home equity -- having the mortgage "under water" as they say -- causes foreclosures.

Theory: a homeowner always has the option to stop paying his mortgage. Although state laws are somewhat different, to a good approximation the worst case scenario for a homeowner who stops paying is that he can no longer own or occupy the house, and may suffer a reduction in his credit rating that might raise his costs of future borrowing. But if the combined present value of these costs were less than the present value of his promised mortgage payments, he can do better than paying in full. That’s probably an important reason why, as of early 2009, more than five million homes were already either in foreclosure or their owners were delinquent on their mortgage payments.

“Inability to pay” is probably not enough by itself to create a foreclosure, because a homeowner unable to pay but with positive home equity may want to sell his home to pay the loan (and thereby retain his home equity) rather than invite foreclosure. Conversely, a person who is quite able to pay might rationally invite foreclosure, for the reason cited in the text above.

Liebowitz (2009) finds that negative equity was a much more important factor than unemployment in causing the foreclosures that occurred in the second half of 2008.

With that said, unemployment probably magnifies the effect of negative equity. If everyone had remained employed, and falling housing prices were all that had happened, then lenders would probably work out a deal with their borrowers so that their negative equity was brought back closer to zero, which would prevent the borrowers from seeing foreclosure as their best option. But when some people are unemployed and others are not, lenders will make more (lose less) by discriminating among borrowers: Likely foreclosing on those in the most financial trouble, working out a deal with those with mediocre incomes, and demanding full payment from those most able to pay.

As I have pointed out, this rational discrimination among borrowers also raises the unemployment rate, so foreclosures may have a bigger effect on unemployment than unemployment has on foreclosures.

Comments

[conceptwizard:]

Medical bills are behind more than 60 percent of U.S. personal bankruptcies, U.S. researchers reported on Thursday in a report they said demonstrates that healthcare reform is on the wrong track.

More than 75 percent of these bankrupt families had health insurance but still were overwhelmed by their medical debts, the team at Harvard Law School, Harvard Medical School and Ohio University reported in the American Journal of Medicine.

Thats a large number and would have to a have an impact on foreclosures as well. I was surprised, I expected traditional debt load. Just a thought.

Jul 05 03:48 AM

[Fighting Yoda:]

Most foreclosures are on loans that had no or low down payments. Underwater seems a plausible cause for foreclosure – but statistically not true. If you had put down money originally you have skin and like with a stock – just because it has gone down you don’t want to sell it.

Walking away from a underwater home is not as easy at sounds – you can end with a tax bill for forgiven loans, higher future cost of borrowing etc are significant deterrents that have to be factored in.

Jul 05 03:57 AM

[reveigel@ms...:]

That article makes absolutely no sense to me at all. Why would a foreclosure affect employment? What am I reading wrong?

Jul 05 08:19 AM

[Middle GA H...:]

The author fails to take into account the very real reduction of home values in the past two years. Two years ago many of the homes in foreclosure had substantial equity in them, now due to the economic contraction those same homes are valued at quite a bit less. He also seems to think that by merely putting a "For Sale" sign on a home with equity, that it will magically sale. Wish that were the case. Many homes throughout the country have been on the market for a year or more and despite reductions in price, have not sold. Much of the problem lies with banks' inability or unwilllingness to lend to even stellar credit applicants. Finally, when the distressed homeowner is involuntarily unemployed with no source of income and has a home sitting with a "For Sale" sign that doesn't sale, the result is simple --Foreclosure.

The esteemed writer fails to see that side of the issue, blaming instead the problem on people who bought more house than they could afford. There is possibly some truth to that thesis, but the concept while being deceptively simple is fatally flawed.

Jul 05 08:57 AM

[Diegojames:]

I live in California. We had home builders everywhere, we had mortgages of all types , we had a binge feeding situation of construction and selling of homes .
Money flowed easily and like the" tulip bulb mania" it burst . Thank you Mr Greenspan -the flim flam man- and a Congress who was not protecting America.
Now the banks will do numbers games. If there is money to be made that is business and it will be necessary to clean up this mess . We are in the "LOST DECADE" FOR AMERICA.
Was this necessary ? I am invested in technology, metals and mining , KO, Ford ,power and food producers and Cisco. We certainly have enough homes, and we have an existing medical system so the next TRILLION DOLLARS spent is not going to produce but reduce our GNP.
If the public demands preventative innoculations for various cancers which are now a reality, we might benefit from this entirely misplaced direction of assisting the economy.
If at all possible force these funds into "job stimulation "through solar panel production throughout the sunbelt, fuel cells, nuclear power plants, rapid trains, hybrid cars- away from Detroit negativity-,wind turbines , de salination plants to produce drinking water, pipelines and nuclear power pumping stations, to move flood waters of excess to dry western states.
America can do "economy changing" projects .

Jul 05 09:29 AM

[Gem Hudson:]

Paying off the Chinese no longer in our paper dollar no longer pay off the debt. Paying down the debt takes money earned or you have a junk bond rating. Because print money is nothing but paper money until earned.

Earned money is capital money and money capital is to produce and to sell what you have produced and an appreciating dollar is in its economics but a depreciating dollar is what cost more than what could be made in the money. Spending more by hyper-inflating more makes the money nothing else but paper money.

Negative equity is when the surplus still is more than what they could ever afford and there is no refinancing.

Jul 05 09:49 AM

[Amusis.com:]

Sorry, but your explanation is completely wrong.

You state that people default because the present value of the cost of default is less than the PV of future mortgage payments.

First, I don't think too many people sit down to prepare spreadsheets calculating discounted cash flows when deciding whether to default or not. In the real world outside academic textbooks, people make irrational decisions.

The real reason is an anchoring bias. People assume that since the home is worthless now (negative equity), they are paying 'something' to get 'nothing', i.e. they assume the home will always be underwater.

In truth, the home value could rise in future, and of course the mortgage principal will be paid down. So the situation could reverse. If people were as rational as you say, the DCF would include the terminal value of the house, meaning they might come to a different conclusion than to walk away.

Academic theories are supposed to help us explain the real world, not wish it away.

Jul 05 12:00 PM

[John Lounsbury:]

Amusis - - -

You wrote: "The real reason is an anchoring bias. People assume that since the home is worthless now (negative equity), they are paying 'something' to get 'nothing', i.e. they assume the home will always be underwater."

Excellent point. This is something I have not seen discussed much. I personally lived through an under water home equity situation in the 1970's. We borrowed everything we could in 1972 and built our dream home in a rural area with a 45 minute commute (because of distance, not because of traffic). Real estate in general in the region I lived had a minor slump though the 70's (major when adjusted for inflation) and our dream home lost market value much more than the average residence because of its remoteness. However, we had put personal equity into the home (about 25%) and the market value decline probably never completely consumed that at the lowest point.

We never considered selling or walking because my job was secure and we loved where we were living, but we struggled with cash flow because the cost of commuting rose several fold, inflation far outstripped income growth and we had three young children consuming more and more of our income each year. We cut expenses any way we could; I hunted for part of our meat; we burned firewood cut on our wooded property to cut down on heating costs; I met coworkers partway to work and carpooled; we bought all our clothes at the church thrift shop; we didn't take vacations - we took the children for walks in the woods; we never went to the movies and ate out once or twice a year. We got by, got into a better cash flow situation by after 12-14 years and the property sold in 2004 for a profit (inflation adjusted and including the expense of a complete remodel 2000-01 and all property taxes paid over 32 years).

Most people who default will do so on a cash flow basis, not a present value calculation. However, unless they love the home, have some feeling of employment security, feel they are not too far underwater (negative equity), and have the expectation that they will be living there for many years to come, they may not take dramatic moves to address the cash flow issues - they are good candidates to walk.

Jul 05 12:30 PM

[Boxed Merlot:]

There's a pony in here somewhere.


On Jul 05 09:49 AM Gem Hudson wrote:

> Paying off the Chinese no longer in our paper dollar no longer pay
> off the debt. Paying down the debt takes money earned or you have
> a junk bond rating. Because print money is nothing but paper money
> until earned.
>
> Earned money is capital money and money capital is to produce and
> to sell what you have produced and an appreciating dollar is in its
> economics but a depreciating dollar is what cost more than what could
> be made in the money. Spending more by hyper-inflating more makes
> the money nothing else but paper money.
>
> Negative equity is when the surplus still is more than what they
> could ever afford and there is no refinancing.

Jul 05 04:46 PM

[Boxed Merlot:]

I'd be curious to see how far back this study went, or when it started and concluded. This would make sense given our previous economic environment, but it doesn't seem to fit too well with our latest dynamic.


On Jul 05 03:48 AM conceptwizard wrote:

> Medical bills are behind more than 60 percent of U.S. personal bankruptcies,
> U.S. researchers reported on Thursday in a report they said demonstrates
> that healthcare reform is on the wrong track.
>
> More than 75 percent of these bankrupt families had health insurance
> but still were overwhelmed by their medical debts, the team at Harvard
> Law School, Harvard Medical School and Ohio University reported in
> the American Journal of Medicine.
>
> Thats a large number and would have to a have an impact on foreclosures
> as well. I was surprised, I expected traditional debt load. Just
> a thought.

Jul 05 04:53 PM

[Alphameister:]

While home-owners might not do a precise cost-benefit analysis in deciding to forego mortgage payments, I think they generally do perform a rational semblance of such analysis. When home-owners with negative equity conclude that home prices are more likely to decline further than to rebound in the foreseeable future, and when they realize that they have an opportunity to live rent-free for the extended period during which the foreclosure process is moving forward (a period in which their suspended mortgage payments permit them to repair balance sheets and/or make purchases not otherwise affordable to them), the temptation to bail out on their mortgage commitment can become irresistible. Indeed, the retail sector has held up better than might have been expected in part because suspended mortgage payments have effectively increased discretionary incomes temporarily.

Jul 05 08:38 PM

[Steve Owen:]

I have seen personal examples of exactly what the author is talking about. Individual calculation of which path is better economically causing the decision to be 'let the bank have it.' I used to believe that large numbers of foreclosures could only happen in an environment with sustained high unemployment, however, in the last few years I have several cases where people followed exactly this economic maxim. I have seen several others consider it and back away... there is still a strong work/repayment ethic in this part of the country. However, in places like California, Florida, and Michigan I believe the author has identified a significant, though small, segment of the foreclosure market. It seems evident that the foreclosures came first and unemployment increases followed, just look at the statistics... but whether that is cause and effect is subject to additional study.

Jul 05 09:49 PM

[Fred Linn:]

What a scholarly and academic sounding article.

--------"Unemployment and foreclosure rates have skyrocketed over the last 1-2 years. The regions experiencing the most unemployment seem also to be the ones that have the highest foreclosure rates."-----

Maybe there is a connection.

-----"Theory: a homeowner always has the option to stop paying his mortgage. "----------

Maybe homeowners don't have an option. Like when they have no money coming in because they are unemployed, savings are used up, and they need to feed the kids.

-----"“Inability to pay” is probably not enough by itself to create a foreclosure, because a homeowner unable to pay but with positive home equity may want to sell his home to pay the loan (and thereby retain his home equity) rather than invite foreclosure. Conversely, a person who is quite able to pay might rationally invite foreclosure, for the reason cited in the text above."--------

Assuming that a) there is any equity left b)that there are any buyers--an high unemployment rate means there are few buyers c) the house can be sold within a time period before the foreclosure closes.

Maybe you should try being unemployed, broke, homeless, hungry, cold and sick with no way out for awhile before you pontificate about hard times. It ain't no fun.

----"........ just look at the statistics... but whether that is cause and effect is subject to additional study."---------

I've done a first hand study----I can tell you it sucks!

Jul 09 01:12 PM