The United States has become intimately and unfortunately familiar with foreclosure. The bursting of the housing bubble, the subsequent recession, and that recession’s intractable persistence have conspired to make foreclosure not just a household term, but a household topic. Yet our newfound knowledge about foreclosure—the painful process, the insidious effects, the ominous risk factors—just scratches the surface of the United States’ housing problems.

About 0.16 percent of homeowners are facing foreclosure as of June 2012, but it is estimated that up to 15 percent of homeowners have negative equity in their homes. That means they now owe more on their mortgage than their house is worth. The yawning gap between foreclosure and negative equity has been largely ignored, despite the fact that negative equity significantly increases the risk of foreclosure. And as research by Brian Melzer, an assistant professor of finance at the Kellogg School of Management, shows, there is a lot about negative equity that we are just beginning to understand.

Negative equity’s most insidious effect is how it changes homeowners’ behavior. “It changes your incentive to invest,” Melzer says. “If there’s some chance that you’re going to default on the asset, then whatever payoffs you create, whatever value’s created in that state of the world will end up going to the lender rather than to you if you end up defaulting on the asset.”

As a result, Melzer’s research shows, homeowners with negative equity invest significantly less in their homes, “about 30 to 40 percent less than a typical positive-equity homeowner.”

“Negative-equity homeowners are not just passing up on cosmetic projects like painting the interior of their home,” Melzer says. “You see similar proportional declines when you look at investments in the guts of the home, so to speak. Things like insulation, plumbing, and electrical work decline in terms of the interior structure. So does spending on the exterior structure, on siding, masonry, roofs, windows, and gutters.” Remodeling and expansion projects also take a hit, and homeowners with negative equity also pay down less of their principal than those with positive equity.

Income Independent
What is revealing about Melzer’s study is that the drop in investment is not dependent on income. Wealthier households earning over $165,000 per year—in other words, people who typically can afford to pay their mortgages and maintain their homes—behave almost identically to people who are financially strapped. “To me, that indicates that the main findings aren’t explained or driven by a financial-constraint type of explanation,” Melzer says. “It’s more the case that people are not investing because they chose not to do so.”

Melzer found these trends hiding in the Consumer Expenditure Survey (CE) run by the Bureau of Labor Statistics. The survey asks a random sample of about 7,500 households to detail their income and expenditures quarterly for one year. Each year the sample population turns over. CE data is chock full of detailed information, and Melzer was interested in household spending, including home improvements and maintenance, home furnishings and appliances, and vehicles. He also looked at what homeowners reported about their mortgage and home equity payments—how much did they pay, and did they make any additional payments over and above what was required? They also reported how much they thought their home was worth as opposed to how much it is actually worth, a distinction that will be important later.

Melzer found that negative-equity homeowners spend around $200 less on maintenance and improvements per quarter—about 30 to 40 percent less than positive-equity homeowners—and $228 less on principal payments per quarter—nearly 50 percent less than people with positive equity. In the cases of households that are not financially constrained—the group with incomes over $165,000—those numbers are larger. They pay over $380 less on unscheduled payments per quarter and over $800 less on maintenance and improvements per quarter.

Following the Money
So where is the money going? Melzer says his analysis does not let him say conclusively where people spend in lieu of payments and maintenance, but there is some suggestive evidence that people are investing in items they can take with them should they be foreclosed upon. Things like appliances, cars, and furniture. On cars, specifically, they spend almost $200 more quarterly.

“The idea is that anything that remains in the home is going to go to the lender, and anything that the homeowners can take with them, they’ll be able to keep in the case of default,” Melzer notes. “Provided the lender doesn’t come after and try to reclaim those.”

In some states, lenders may do exactly that. In so-called recourse states, laws allow banks to essentially sue foreclosed homeowners to recoup any outstanding balance. In theory, this should coax homeowners into meeting their obligations, or at least not falling as far behind. Indeed, Melzer finds that negative-equity homeowners in recourse states do make about $80 more in principal payments than those in nonrecourse states, but still less than positive-equity homeowners. He finds a similar trend for maintenance and improvements spending, but cautions that this difference is not statistically significant.

Once a homeowner dips into negative equity, there does not seem to be much that will persuade him or her to behave like a positive-equity homeowner—in other words, to make additional payments and invest in maintenance and improvements. That spells trouble for the housing industry. “My results suggest that home prices will grow more slowly in the future because there’s less money being invested in improving the quality of the existing housing stock,” Melzer says. “There’s also less money being put into expanding the quantity of the housing stock, not in terms of building new homes, but in terms of adding to existing homes.”

As a result, Melzer says he expects housing prices to grow more slowly. He estimates that roughly one-third to one-half of typical growth is attributable to home improvements and maintenance. Given that negative-equity homeowners represent up to 15 percent of all homeowners, and given that they are cutting back on those value-adding expenses by 30 to 40 percent, then home prices may continue to sag until the negative-equity problem is resolved.

Dragging Down the Recovery
If home prices continue to lag, then the economic recovery may still be a ways off. “In the past, if housing wasn’t the reason for the recession, generally people had fairly good equity stakes in their homes still. So as you went through the recovery, they still had an incentive to invest in their home,” Melzer points out. People were more willing to spend money on their homes, which helped consumer spending and thus the recovery. But the current recession has been driven in part by a decline in home prices. As a result, homeowners have been investing less, potentially hampering the recovery.

If there is a light at the end of this tunnel, it is that homeowners are somewhat naïve when it comes to the value of their homes. “In other studies, researchers have found that people overestimate the value of their home anywhere from five to ten percent,” Melzer says. In other words, the problems surrounding negative equity could be even worse.

Fixing them will not be easy, but there are some possible solutions. One is to let the foreclosure process continue its slow grind through the housing sector. But that is not ideal, Melzer says, because it prolongs the destruction of value that begins when homeowners enter negative equity. A better choice would be to modify people’s mortgages, whether that be by restructuring payments or even reducing principal.

Banks are loathe to reduce principal on mortgages—those are losses they have to enter into their books, while there is a remote possibility that a foreclosed home could sell for what they are owed. But using Melzer’s research as a guide, principal reduction would be a logical and expedient option to halt value destruction in the housing sector. Principal reduction makes people “more willing to act like owners,” Melzer says, which would encourage people to spend more on maintenance and improvements. And an uptick in consumer spending is just what this economy needs.


Related reading on Kellogg Insight

The Real Costs of Credit Access: Evidence from the payday lending market

Money and Mores in the Mortgage Meltdown: When “illegal” and “immoral” failed to coincide

Walking Away: Moral, social, and financial factors influence mortgage default decisions