Equity Extraction and Mortgage Default: Understanding why Early Home-buyers Defaulted during the Housing Bust

Using a property-level data set of houses in Los Angeles County, I estimate that 30% of the recent surge in mortgage defaults is attributable to early home-buyers who would not have defaulted had they not borrowed against the rising value of their homes during the boom. I develop and estimate a structural model capable of explaining the patterns of both equity extraction and default observed among this group of homeowners. In the model, most of these defaults are attributable to the high loan-to-value ratios generated by this additional borrowing combined with the expectation that house prices would continue to decline. Only 30% are the result of income shocks and liquidity constraints. I use this model to analyze a policy that limits the maximum size of cash-out refinances to 80% of the current house value. I find that this restriction would reduce house prices by 14% and defaults by 28%. Despite the reduced borrowing opportunities, the welfare gain from this policy for new homeowners is equivalent to 3.2% of consumption because of their ability to purchase houses at lower prices. JEL Codes: D14, G21, G33, E20, R20. ∗[email protected]. This paper is a revised version of the first chapter of my NYU Ph.D. dissertation. I thank Andrew Caplin, Chris Flinn and Stijn Van Nieuwerburgh for their help as well as their general encouragement. I have also benefited from conversations with Manolis Galenianos, Ahu Gemici, Antonio Guarino, John Leahy, Chris Mayer, Jesse Perla, Kevin Thom, Chris Tonetti, Joe Tracy, Håkon Tretvoll, Gianluca Violante, Paul Willen, Matt Wiswall, Karen Pence, as well as seminar participants at the NYU, the University of Michigan, the Federal Housing Finance Agency, the US Census Bureau, the Federal Reserve Board, Cornerstone Research, Ohio State University, Yeshiva University, Johns Hopkins University and the Consumer Financial Protection Bureau. I also wish to thank Ronel Elul and Tomasz Piskorski for helpful discussions. Special thanks to the economists at the Federal Reserve Bank of New York for their hospitality and for much helpful feedback. Finally, I wish to thank to Gunnar Blix and Marco Scoffier for their help with the data. All remaining errors are my own. The views expressed in this paper are solely those of the author and not necessarily those of the Federal Reserve Board or others within the Federal Reserve System.