Social Networks and Foreclosures – Common Thread

Do social networks and foreclosures have something in common?
Yes! They are both contagious…

One of the most fascinating things about a financial crisis – if it lasts long enough – is that while you’re living through it you actually start to see research from various institutions concerning why the crisis has occurred and how to respond to it. In our current state of mass foreclosure, the University of Chicago Booth School of Business and the Kellogg School of Management at Northwestern University have drafted a paper that addresses the root cause of the foreclosure crisis.

Up until now, both the Bush and Obama Administrations have been focusing on using government funding to support mortgage modifications, thinking that by reducing the monthly cash flow obligations of particular families or investors that the level of defaults will, in fact, decrease.

While fundamentally the government may not be completely wrong about how to resolve the crisis, one area that they clearly are not addressing is the fact that as much as 26 percent of all mortgage defaults are not based on an individual’s inability to pay, but rather is based on an individual’s decision not to pay their mortgage because the value of the property has decreased substantially. In the University of Chicago and Northwestern study, these decisions are called “strategic defaults.”

Particularly, they are finding that strategic defaults start to increase substantially when the value of the house or property decreases in excess of 50 percent of the value of the mortgage.

The researchers, according to Zillow.com, have determined that approximately 22 percent of all households have negative equity in their homes while in some areas such as Las Vegas and California, the amount of negative equity exceeds 50 percent.

The researchers further claim that current government policy was based primarily on research done during the 19901991 recession whereby it was determined that in Massachusetts only 6.4 percent of the population with mortgages chose to walk away from their houses when their home equity was negative.

Thus, the current researchers have had to distinguish what is different about this recession and this foreclosure crisis with that of the early 1990s in Massachusetts.

Clearly, one of the distinctions that exists is that in Massachusetts the prices from peak to trough did not fall in excess of 20 percent while in many areas in the United States the amount of equity that has been lost from the peak of the market well exceeds 20 percent.

Most importantly and also most alarming, is that the researchers were able to definitively conclude that once foreclosures start in a particular neighborhood or zip code, strategic defaults rise substantially and the moral misgivings associated with walking away start to erode.

In other words, if you know people who are in foreclosure, you may be more likely to decide to also go into foreclosure. That reminds me of a recent study that determined that those individuals who have friends that are happy, or friends of friends that are happy, are more likely also to be happy.

Ironically, we are now finding that the rules of social networks apply both to good and bad situations… but that misery does indeed enjoy company, at least when it comes to the general population and how foreclosure is perceived by individuals within a particular community.

Most importantly, however, are the implications associated with idea of foreclosure and the contagion of foreclosure if the government does not figure out a way to create a public policy that will stabilize the housing stock. It appears that merely throwing money into the mortgage modification process will not be enough. Rather, the government will need to create true incentives to allow first-time home buyers to jump into the market, as well as, to encourage investors and hedge funds to pick up the excess housing stock, thereby re-stabilizing housing pricing and ensuring that pricing does not continue to erode.

Clearly this study indicates that if we are able to reverse the continued decline of housing prices or at least prevent their continued erosion, then the foreclosure crisis would be able to resolve itself in an orderly fashion. However, on the flip side, if prices continue to erode it is only logical and rational that individuals will continue to walk away from their properties and make strategic decisions that it is just not worth continuing to throw good money after bad. This is particularly true when your friends and relatives are throwing in the towel.

For more information on this topic, view Roy Oppenheim’s social networks and foreclosures video.

From the Trenches.