Study: Defaults come when home equity hits 62 percent of purchase

The average homeowner doesn't think about making a "strategic default" on his mortgage until equity falls to 62 percent of the home's value, a study from the Federal Reserve Board showed.

Strategic mortgage defaults have grown into a troubling trend in Las Vegas, where 75 percent of homeowners are underwater, owing more than their home is worth, First American CoreLogic reported.

The Federal Reserve study released this week looked at borrowers in Nevada, Arizona, California and Florida -- the hardest-hit states in the housing crisis -- who purchased homes in 2006 using subprime mortgages with 100 percent financing.

Almost 80 percent of those borrowers defaulted by the end of September 2009.

"Many borrowers in our sample bought houses at the peak of a housing bubble, put no money down and seemingly had little to lose, financially, by walking away once their values dropped," the report said. "Yet they pay a substantial premium over market rents to keep their homes."

After distinguishing between defaults caused by job losses and other income setbacks and those caused purely by negative equity, the study found that a decline to 62 percent of home value was the number that induces strategic defaults.

"Our estimates show that about 80 percent of defaults in our sample are the result of income shocks combined with negative equity," the report said. "However, when equity falls below 50 percent, half of the defaults are driven purely by negative equity."

A central question in the Federal Reserve study is at what point underwater homeowners walk away from their homes, even if they can afford to pay.

While there has been anecdotal evidence of homeowners who choose to walk away when they owe 20 percent or 30 percent more than the value of their homes, there has been scant academic research about how systematic this type of behavior is among underwater households or on the level of negative equity at which the decision is made, the study found.

Las Vegas housing analyst Dennis Smith of Home Builders Research said there's no way to identify a specific breaking point at which someone will walk away. It depends on individual circumstances, including age. Someone in their 20s can take a seven-year hit on their credit score better than someone in their 50s, he said.

"I think it's hard to judge people on what's considered a moral issue and a legal obligation without knowing their circumstance, without knowing their family situation," Smith said. "You have to do what's best for you and your family, and if that means walking away from 40 percent, 50 percent, 60 percent negative equity, I don't blame them at all."

Monthly foreclosure activity in Nevada rose 10 percent in April from the previous month to 16,217 foreclosure filings, according to Irvine, Calif.-based RealtyTrac foreclosure listing service. Mortgage default filings have increased 15 percent from a year ago.

People are walking away from their mortgages by the thousands, making a financial decision that it's better to take the credit hit than try to recover their loss in home value. With Las Vegas home prices down more than 50 percent from the peak, some homeowners have negative equity in the hundreds of thousands of dollars.

"Unless there are steps taken by the banks to re-evaluate the value of properties, in other words principal reduction, I think there's going to be a lot more of these strategic walks," Smith said.

Moral and social variables play a significant role in predicting strategic defaults, according to research from Kellogg School of Management at Northwestern University and University of Chicago Booth School of Business.

People surveyed who said it was immoral to default were 77 percent less likely to declare their intention to do so, while people who know someone who defaulted were 82 percent more likely to say they would default themselves.

The Fed study noted that mortgage borrowers tend to view default as immoral, although 17 percent of survey respondents said they still would default if equity declined to 50 percent.

"I've thought about it, but I signed the paperwork to refinance the house," Las Vegas homeowner Janet Barbour said. "This mess with housing in Las Vegas and the problems with the banks ... I'm current with my mortgage. Of course, I'm under water. I went to Bank of America and all I asked them to do is reduce the interest rate. That 2 percent represents a large chunk of money out of my pocket."

Contact reporter Hubble Smith at hsmith@reviewjournal.com or 702-383-0491.