Mortgage Default and Bankruptcy: Theory and Empirical Evidence Wenli Li, FRB Philadelphia Michelle J. White, UCSD and NBER
What we do: • Examine the interaction of homeowners’ decisions to default on their mortgages and file for bankruptcy. • We test: • Whether homeowners are more likely to default versus file for bankruptcy when they gain financially from either, and • Whether homeowners are more likely to default versus file for bankruptcy when they are liquidity-constrained. • We use new data that combines information on mortgage debt and other types of debt. • Previously, the literatures on mortgage default and bankruptcy were separate because of lack of combined data.
How are mortgage default and bankruptcy decisions related? • Bankruptcy helps homeowners avoid mortgage default/keep their homes by discharging unsecured debt. • Bankruptcy helps homeowners keep their homes by delaying foreclosure and allows homeowners to repay mortgage arrears over five years. • But bankruptcy helps homeowners with high income or high assets less, since they must use repay from future income and assets. • Default helps homeowners preserve access to credit card loans—some choose default/avoid bankruptcy. • Bankruptcy helps homeowners give up their homes by discharging deficiency judgments.
Notes: • Diagram is separately calculated for each homeowner. • As shown it assumes that bankruptcy reform is in effect (means test), mortgage debt is fixed, and unsecured debt is fixed and high. • Homeowners are predicted to default and file for bankruptcy only when it is in their financial interest. • D/B predicted when house value is low and income is low. (House value is low enough that the cost of renting < cost of owning.) • D/NB predicted when V is low and Y is high. • ND/B predicted when V is higher and Y is high. (Here the income boundary between B and NB shifts to the right because of homeowners’ gains from filing for bankruptcy.) • ND/NB applies when V and Y are both high and when V is very high and Y is low. (Best not to default because must repay unsec debt from sale proceeds of the house.)
Notes: • Now some additional homeowners default even when it is against their financial interest b/c V is high. They default because of liquidity constraints.
Data: We merge three datasets: • LPS: large sample of mortgages with information from the mortgage application, plus monthly updates on payment and bankruptcy. • Equifax: sample of individuals with information about all types of debt, plus quarterly updates on payment, credit scores, debt-to-income ratio. • HMDA: use it to merge LPS and Equifax based on date/location/principal of mortgage.
Final dataset: • All mortgages originated 2004-2006. • They are followed quarterly until the mortgage is paid off or transferred, the homeowner defaults or files for bankruptcy, or at the end of 2009. • Currently, we include only prime, fixed rate mortgages. • Each quarter, we also have: • Amount owed and payment record for second mortgages, credit card debts, student loans, auto loans, and installment loans. (Half of each debt if homeowner married.) • Updated credit score and debt-to-income ratio. • Income at origination and homeowner’s age, sex, marital status.
Specification: • We estimate a multi-probit model explaining: • Default/no bankruptcy (aD/NB). • No default/bankruptcy (aND/B). • Relative to no default/no bankruptcy (aND/NB). • We drop simultaneous default/bankruptcy because it’s very rare (aD/B). • Main variables of interest are the predicted decision variables D/NB, ND/B, D/B. • Control variables, quarter and state dummies. • Errors clustered by mortgage.
Add liquidity constraint: • Rerun the model with an additional dummy variable for homeowners who are liquidity-constrained—combined debt payments are more than 50% of income. • % of observations that are liquidity-constrained? • Everything else remains the same.
Conclusions: • Homeowners’ mortgage default and bankruptcy decisions respond strongly to financial benefit. are related. • The two decisions are related—homeowners are more likely to file for bankruptcy. • Liquidity constraints make homeowners more likely to do both.
Future work: • Examine subprime mortgages and adjustable rate mortgages. • Compare results when default and bankruptcy decisions are independent.