Friday, July 3, 2009

Can Unemployment be Blamed for the Foreclosure Crisis?

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 an effect on unemployment than unemployment has on foreclosures.


Milton Recht said...

In addition to unemployment, illness, divorce, death of wage earner, unexpected large expenses, such as medical expenses, partial loss of wages, etc. cause an inability to continue to pay the mortgage and contribute to mortgage defaults.

Normally, a homeowner can refinance or sell to avoid foreclosure, but negative equity removes those options as a way to payoff the debt and prevent a foreclosure.

fl said...

It makes sense that unless the property is underwater, there should be no foreclosure. However, some owners might choose to continue payments on their house even though they are underwater. This is going to be true if the owners have build up consumer rents from living in the property.

This is probably true for quite a few owners, especially if they have invested into making friends with neighbours, into features of the house that they might enjoy more than others, by having their children go to the neighborhood school. I think it is reasonable to think that consumer rents are especially important in the housing market.

If this is true, then unemployment could at least theoretically be an important driver of the foreclosure crisis. Whether this is true empirically is a different question.

Anonymous said...

Who believes that unemployment is the primary cause of foreclosures?

Mario Rizzo

Anonymous said...

This is just one more reminder that the only real way to keep our economy strong is not by raising taxes, but by keeping taxes low, fair and simple. I've been looking for a way to take action and contact our legislators and sign petitions and found some good policy the U.S. Chamber of Commerce backs (here). I don't have a lot of money or time, but I figure this will help other people do good.