Bankruptcy

Are the Rich More Likely to Default on Their Mortgages?

By Adam Levitin

The NY Times has an article about mortgage default rates being higher on larger (>$1M) mortgages than on small mortgages.  The argument suggested by the article is that the rich are more likely to see their homes simply as investments.  Put a different way, the consumption utility component of the home is relatively less important to the rich.  A house has two value components--it's an investment, and it is also a consumable (but durable) product.   The consumption value of a home is basically the same for everyone--I might derive more or less utility from any particular house, but it is all within a relatively constrained range, and my range is probably around the same as everyone else's.  That means that the consumption value component of a house is largely fixed, regardless of the house's price.  The more expensive the house, the smaller the ratio of the consumption value to the investment value.  Therefore, it would follow that people with more expensive houses place more value on the investment component and treat the house more like an investment.  

I think that's correct, but I also think there's more going on and wish that the analysis in the article had dug deeper because it has unfortunately fed into a narrative of the mortgage crisis being one of strategic default by ruthless investors, with the corollary being that they do not merit any government assistance and even deserve opprobrium or punishment (although they are only playing by the rules of the game, which should have been priced in by lenders).  Here's what I wish the story had pointed out:

(1) Only a small fraction of mortgages are for over $1M.  The median mortgage is $200K.  That is to say, even if default rates are much higher on >$1M mortgages, that's still a relatively small piece of the mortgage problem.

(2) There's likely a California effect biasing the results.  California has a lot of mortgages, very high housing prices, and very high default rates.  Putting California mortgages into a comparison with, say, Kansas mortgages just doesn't make a lot of sense.  You'll see higher default rates on high priced mortgages simply because there aren't very many Kansas mortgages over $1M, which a $1M mortgage isn't particularly special in California.  I would really have liked to see the default analysis conducted in state (or MSA) markets--are default rates higher on big mortgages in Kansas?  Are default rates higher on bigger mortgages in California (with some adjustment for local housing prices to reflect what is a "big" mortgage).  I suspect that when one looks market by market, the disparity in default rates between larger and smaller mortgages is less stark.  (I would also be interested in seeing if there is a noticeable difference in default rates between $900K and $1M mortgages).  

(3) The difference in the default rates might also be partially explained by mortgage product type.  My non-empirical sense is that payment-option and interest-only mortgages were relatively more common for large mortgages.  These types of mortgages were often underwritten to the initial minimum payment.  Therefore, it wouldn't be a surprise to see default rates being higher in the high-end market if these mortgages were more common there.  

(4) Let's be careful about equating a large mortgage with being rich.  Somehow it seems that nearly everyone in the US considers themselves "middle class," but we should distinguish between wealth (accumulated value) and income (gross stream of value).  You do not need to be wealthy to get a big mortgage.  Indeed, a mortgage is debt (negative wealth), and if you are really wealthy, you might very well eschew a mortgage and just pay in full.  But during the housing bubble, you could get a large mortgage based solely on income or even based on stated income.  People who had large incomes in 2005 and 2006 might not have such large incomes today.  Consider, for example, a mortgage broker or realtor whose income in 2005-2006 could potentially have been quite large, but today might be unemployed.  

(5) It might be that those with large mortgages are more vulnerable to income shocks because it is harder to make up lost income.  That is, if your mortgage payment is $12K/mo, and your household income is reduced (say one spouse is laid off), so that you can only cover $7.2K/mo, it's a lot harder to scrape up the difference than if your mortgage is $2K/mo and you can only cover $1.2K/mo.  A second low-paying job or help from family and friends or even things like yard sales can help bridge an extra $800, but bridging an extra $4,000 is more difficult.  

Full post as published by Credit Slips on July 12, 2010 (boomark / email).