Finance & Accounting Aug 3, 2012

Housing’s Alba­tross

Neg­a­tive equi­ty weighs on the market

Based on the research of

Brian Melzer

Listening: Interview with Brian Meltzer on Housing

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The Unit­ed States has become inti­mate­ly and unfor­tu­nate­ly famil­iar with foreclosure. 

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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.”

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

Featured Faculty

Brian Melzer

Member of the Department of Finance faculty until 2018

About the Writer

Tim De Chant was science writer and editor of Kellogg Insight between 2009 and 2012.

About the Research

Melzer, Brian T.. 2012. “Mortgage Debt Overhang: Reduced Investment by Homeowners with Negative Equity.” Working paper, Kellogg School of Management.

Read the original

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