Sorry, I wasn't pessimistic enough

The house price decline from top to bottom will now pretty clearly be larger than I predicted. The decline in 2007, according to the Case-Shiller index, was almost 10%; more ominously, in the fourth quarter of 2007, prices were dropping at a 20% annual rate. It thus seems unlikely that the overall decline in house prices will be limited to 20%, and more probable that when prices finally turn, they will have dropped 25-30%, with drops of as much as 50% in some heavily speculative markets such as much of California. This is an exceptional outcome by US standards, ranking with the 1930s as a house price downturn, but it must be remembered that in Japan Tokyo house prices dropped by over 70% from their 1990 peak before stabilizing.

The depth of house price declines has a near-exponential effect on mortgage defaults, since a borrower can walk away from a home mortgage without declaring bankruptcy - the transactions are generally non-recourse. Roubini estimates that if house prices decline 20% 16 million mortgages would be "under water" with principal amount greater than the value of the underlying asset, and that 50% of those underwater mortgages will default. If house prices decline 30%, 21 million mortgages will be underwater, with the same percentage defaulting.

At the lower price decline, that seems to me a little pessimistic. A borrower who can make payments on his mortgage, and whose house is temporarily worth 5% or even 10% less than the mortgage is unlikely to default, if only because he has to live somewhere and moving costs, let alone real estate brokerage costs, are substantial (he would also damage his credit rating.) Thus once we get beyond the universe of people who should never have had a mortgage in the first place, a moderate decline in house prices does not necessarily hugely increase defaults. However as price declines approach the 25-30% level, let alone the 50% that is possible in California, the percentage of mortgages defaulting is likely to rise sharply.

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[ via Carolyn Baker ]