Going Nowhere: How Housing Bust Impedes Mobility

• Housing busts and rising foreclosures can force some households to move, but others can find themselves locked into their current homes.

• Around 12% of American homeowners typically move in any two-year period; yet, families with negative equity are around half as likely to relocate. Those facing higher mortgage rates are 25% less likely to move.

• Most households with negative equity do not have sufficient liquid reserves to cover the costs of moving, and thus are locked into their current homes until the market recovers.

• Lower mobility associated with mortgage lock-in can have important effects on local labor markets, housing finance, and public policy.

The current market downturn has raised fears that local communities will suffer, socially as well as economically, as foreclosures force defaulting homeowners to move. One recent media report indicates that 220,000 households lost their homes to foreclosure during the second quarter of 2008, nearly triple the number in the same period of 2007.

Yet, housing busts do not just increase the foreclosure rate: They also influence residential mobility and the labor market. Default-induced moves are the first mobility-related impact observed during a downturn, but they might be the most important to a regional economy. Research indicates that factors such as falling home prices and rising interest rates can also lock in homeowners, making it harder for them to relocate for jobs or changing family circumstances.

Whether negative equity and higher mortgage rates raise or lower mobility depends on whether the default or lock-in effect dominates over time. The homeowner’s default option is well-studied in the real estate finance literature, and the exercise of that option clearly has been increasing recently. However, the potential for the lock-in effect to dominate has been recognized since the mid-1990s.

Lock-in effects

There are two reasons that mobility may be reduced substantially in a stagnant or declining housing market. One is that owners suffering from very low or negative equity are credit-constrained, so they need other liquid assets to cover the negative equity or high transaction costs associated with moving. Most households do not have sufficient liquid reserves, and thus are locked into their current homes until the market recovers. Rising interest rates also can lock people in; since mortgage debt is not transferable, a household must take out a new loan at the higher rate to purchase the next home.

Mobility can also fall substantially in downturns for psychological reasons. Even households that are not credit-constrained may opt not to move rather than suffer a nominal loss on their current home. Such loss aversion has been shown to be important in the housing market as well as in other investments.

Americans are quite mobile as a group: About 12% of homeowning households move within a typical two-year period, according to the American Housing Survey. In research I recently conducted with my colleagues Fernando Ferreira and Joseph Tracy, we estimate the overall impact of negative equity and higher interest rates on homeowner mobility using data going back to the 1980s. The estimated impact of lock-in on mobility is quite large. For example, having negative equity reduces the two-year mobility rate by 5.6 percentage points—all else being equal—cutting the baseline mobility rate of 12% by almost half. A $1,000 higher real annual mortgage interest cost is estimated to reduce mobility by 2.8 percentage points, or about one-quarter.

By definition, lower mobility can be observed only over time, so it will take a few years to know how the impact of negative equity will play out in this cycle. These findings also cannot simply be extrapolated inito the future, because housing market conditions are not the same over time. For example, the subprime market was much smaller over most of our sample period, so the underlying riskiness of borrowers was probably lower in the past. In addition, our sample is restricted to owner-occupied homes and excludes investors and second homes, both of which may respond differently to negative equity situations.

The California experience

However, the past often is our only guide, and there certainly have been pronounced shifts over time in house values, leverage and mobility rates. For example, 1985 to 1997 saw a substantial boom and bust in California housing markets. Data from the biennial American Housing Survey for metropolitan areas in that state show a peak in mean nominal house prices of $253,617 in 1989, with an average loan-to-value ratio of 67%, and a two-year mobility rate of just over 15%. Prices in California began to fall around 1991, but did not bottom out until 1997, when they reached $201,693, with an average LTV of 78 % and a two-year mobility rate of only 11.7%. From peak to trough, nominal prices fell just over 20%, with the mean loan-to-value ratio increasing by 16%. It was not until 1998-1999 that mobility returned to the pre-1989 peak at 15.8%. Other markets such as Boston where prices and loan-to-value ratios swung sharply show similar mobility patterns.

There is no doubt that lock-in effects appear ripe to become economically important in some markets once again. In the San Francisco Bay Area, the typical sales price from 1997 to 2007 rose from about $200,000 to $800,000, according to DataQuick. The S&P/Case-Shiller home price index for that market indicates prices have dropped more than 25% since the peak.

DataQuick information also indicates that very high loan-to-value ratios have become common in the Bay Area. The typical LTV on a home purchase was fairly stable around 80% until the end of 2002. Beginning in 2003, there was a sharp increase, with the median LTV hitting 90% in 2004. Loan-to-value ratios stayed at that level for a few years, but have come down since then, returning to 80% in the most recent data we have. We calculate that more than 50% of homebuyers in the Bay Area in 2006 had leverage levels above 85%.

Rising rates, falling equity

Owners also can get locked into their existing homes if mortgage interest rates rise. This may have been an important constraint recently for borrowers who needed a jumbo mortgage to finance a trade-up purchase. From 2003 to 2006, the average spread between prime jumbo and prime conforming mortgage rates was 26 basis points. As financing dried up in the jumbo market in the fall of 2007, the interest rate spread between prime jumbo and prime conforming mortgages widened significantly, reaching 150 basis points in late March, before the credit crunch became even more severe.

Because market conditions differ over time and the effect on mobility plays out over years, our point estimates do not precisely predict mobility effects associated with the current housing market. However, it is clear that the consequences of lock-in and reduced mobility are very different from those associated with foreclosure and increased mobility. For example, lower mobility is likely to result in more inefficient matching in the labor market, as some households will not be able to move to take better jobs. Utility also will be lower to the extent that households are not able to move as readily as they would like to gain access to good schools, for example, or to just find a different-sized home if the family needs a change.

Recent research suggests that owners with negative equity behave more like renters and reinvest less in their residences. It also is possible that the reduced mobility associated with mortgage lock-in can have local public-finance effects. Previous research has shown that even households without children often support investments to improve school quality because these improvements are capitalized into house values. For households with negative equity in their homes, however, that linkage is broken because it is the lender, not the owner, who benefits from any increase in property values.

A case for intervention?

Research is urgently needed to examine these potential consequences and assess their importance. More analysis also is necessary to determine whether there is a case for public policy to intervene in response to mortgage lock-in. For example, it seems likely that lenders would try to avoid letting houses deteriorate through lack of maintenance. It is not at all clear, however, that markets will overcome the inefficiencies in labor matching and housing market matching. Whether such costs would justify government intervention is not obvious, but a clear accounting of the potential benefits is needed to weigh against the typical costs—such as moral hazard—that economists rightly associate with such policies. Whatever the correct answer, the calculus is sure to be different from that associated with the problem of household displacement through foreclosure.

Finally, reduced mobility may mean fewer housing transactions generally, delaying a recovery in those troubled markets. Eventually, population growth and a slower pace of new building will restore a supply-demand equilibrium. However, lock-in effects that reduce the ability of homeowners to trade up or down will counter those fundamentals. This is yet another reason why the recovery in housing will be slow.

Joseph Gyourko is the Martin Bucksbaum Professor of Real Estate and Finance at the Wharton School of the University of Pennsylvania. This article is condensed from a recent paper, Housing Busts and Household Mobility published by the National Bureau of Economic Research.