Why underwater mortgages lead to foreclosures

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A reader writes, in response to my column of a couple weeks back about the pre-Fannie-Freddie-bailout housing bill:

All this mumbo jumbo coming out of D.C. and the financial community is so much smoke screen. Don’t fall for it. Question EVERY single thing they say. Force them back to the basics.

For example, you reported that the finance industry is saying, “The fear is that mass foreclosures could accelerate price declines, bringing on a cascade of additional foreclosures . . .” AND “9 million U.S. homeowners owe more than their houses are worth; they’re upside down, in the parlance, meaning that if foreclosures are to be slowed, the mortgages themselves must shrink.” Both of these statements are nonsense!!

If I own a house that I have a mortgage on, and 4 guys down the street default, and the price of houses in the neighborhood decline, it has NO effect, ZERO, on me as long as I just keep paying my mortgage and live in the house. The only time it would effect me is when I needed to sell. The same logic applies to the second statement. …

I hear this argument a lot, so let me repeat the explanation for why underwater mortgages bring on more foreclosures: People who are underwater on their mortgages are much more likely to default and be foreclosured upon than people who aren’t. If you’re having trouble making your payments but you still have positive equity, you can sell or take out a second loan to avoid foreclosure. If you’re underwater, neither of those options is really available to you. This Boston Fed study, published in May, found declining house prices to be the biggest single factor in generating foreclosures.

What started this real estate mess was that lots of people got mortgages they couldn’t ever hope to pay back unless house prices kept rising. Now we’re reaching the point where even people with less-dodgy mortgages are running into trouble because of declining prices. The vast majority of homeowners who are underwater on their mortgages will keep making their payments. But being underwater significantly increases the risk of foreclosure. And having lots of foreclosures in a neighborhood tends to accelerate the decline in house prices.

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