Why would under-water mortgages cause unemployment?

7/12/2013 11:40:00 AM
Mark Thoma cites a study by the Cleveland Fed which shows that, in fact, the conventional story about underwater mortgages preventing people from moving to accept job offers is not only empirically unjustifiable, but also theoretically incoherent.

The conventional story was this: the recession hit and house prices declined. For a lot of people, this meant that their house price was now less than what they owed on the mortgage, which, so the story goes, implies that they can't move because they can't afford to pay off the loss on their house. And if they can't move, then it they can't accept a new job further away.

Never mind that everyone has a car and that you don't really need to be able to move to avoid unemployment. Does this story even make sense? No. Because the premise that you have to pay off the loss--the difference between what you owe on the mortgage and what you can get for the house--is false. By law, all mortgages in the US are non-recourse, meaning that if you default on your mortgage, the bank can take your house but nothing else.

Ok, back up. Defaulting on your mortgage does involve a cost: it hurts your credit score. Wait, it does? Lets suppose you are a lender deciding who is the most credit worth person to lend to. There are two candidates: one is a guy who is currently struggling to make payments on an underwater mortgage. The other is a guy who defaulted as soon as his mortgage was underwater.

Legally, the first guy is under no obligation to repay another cent of his mortgage--as far as the law is concerned, he no longer really owes any money (I get that you can't keep the house if you default. But these guys want to move out of town any way, ok?). You are the credit rater, so you can't cite the credit rating effects as a reason this guy should continue to pay his mortgage--the rational thing for him to do financially is to default, but instead he is spending every last dime he has to pay back a guy he no longer owes anything to. With all his savings eaten up by an underwater mortgage he can't afford, and no potential to refinance the mortgage since it is now underwater, he could be forced into personal bankruptcy at any second (for example, if he gets sick and winds up having to pay a high deductible on his new, cheaper health plan he switched to to help pay back his mortgage).

The second guy, by contrast, defaulted as soon as the house went underwater. He still has his low-deductible health plan, not a dime has been taken out of his retirement plans, and his cash flow is more than adequate now that he no longer has mortgage payments to make.

So tell me, which of these two do you want to make a loan to?

Ok, maybe the credit ratings aren't supposed to track credit-worthiness in real time, but are supposed to be more of a long-term barometer of the likelihood of repayment. So lets fast forward a decade: the first guy managed to squeak through and keep his house. He still owes tons of money on his mortgage, but house prices recovered to pre-recession level and it's no longer underwater. Yet, even then, we see that the second guy is doing better: he bought himself a new house shortly after defaulting (lets assume you gave him a good enough credit rating to do so), when house prices are at rock bottom. As a result his equity has risen much faster than he's paid down the principle. In addition, he has tens of thousands more in his retirement and savings account, because he didn't have to raid them to pay off an underwater mortgage. Which one do you want to lend to?

This is all to say that in the absence of credit ratings, the rational and financially responsible thing to do when you are underwater is to default. If you are an objective credit ratings agency, the rational thing to do is give the higher credit score to the guy who did the rational financially responsible thing and defaulted. If you are a lender looking to make a new loan, the lower-risk option is to give the loan to the guy who defaults when doing so improves his finances--you can't insulate your portfolio from a market decline, but you can insulate it from idiosyncratic risks and this guy has a lower idiosyncratic risk because he doesn't risk personal bankruptcy over an underwater mortgage. BUT, if you are a credit ratings agency working for a cartel of bankers who have already issued these loans to these guys, you would want to severely punish anyone who defaults on one of your cartel members' loans, regardless of how it affects their forward-looking idiosyncratic risk.

As a general principle, I'm pretty skeptical of the value of credit ratings. I tend to think they serve more to 1)enforce tacit cartel agreements and 2)signal willingness-to-pay to a non-competitive banking cartel, who uses that information to engage in price discrimination rather than risk diversification. But I'm open for your thoughts, and especially any research if any one knows of papers on credit ratings agencies.