Did underwater mortgages kill the economy?

by 18 Apr 2013

The housing market, finally, is recovering. Home prices are up 8 percent over the past year. And that is providing relief to a particular set of homeowners – the underwater borrowers who owe more than their properties are worth. Over past year alone, 1.7 million homeowners have climbed out from being underwater.

These positive developments have boosted the overall economy, even as it faces other headwinds. But they also raise a difficult question: How much has the phenomenon of people being underwater on their mortgages – rather than simply the decline in home prices – held back growth?

A recently revised paper by Atif Mian of Princeton, Amir Sufi of the University of Chicago Booth School of Business and Kamalesh Rao of MasterCard Advisers suggests that underwater mortgages have played a significant role in holding back the recovery. The paper, “Household Balance Sheets, Consumption and the Economic Slump,” was first released several years ago, but it has been revised to include an important new calculation.

It is widely recognized that the fall in housing prices had a “wealth effect” that led homeowners across the country to cut back on spending. In the updated paper, Mian, Sufi and Rao measured how much more underwater borrowers probably  cut back on spending compared to borrowers without an overhang of mortgage debt. (More precisely, they measured how much homeowners cut back on auto spending for each dollar loss of housing wealth. But that’s important; the decline in auto sales was a significant part of the economic contraction.)

The authors found that being underwater makes a big difference. As the chart below shows, Zip codes with fewer than 15 percent of homeowners only cut back only a little – spending only half a cent less for every dollar their home fell in value. But in Zip codes where more than 50 percent of homeowners were underwater, borrowers cut back five times as much – spending 2.5 cents less on car purchases for each dollar of reduced housing wealth.

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