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Economic Brief
SEPTEMBER 2009, EB09-09

Deterring Default:
Why Some State Laws
Decrease the Probability
of Mortgage Foreclosures
By Andra C. Ghent, Marianna Kudlyak,
and Stephen Slivinski

Many states give mortgage lenders
strong legal means by which to
pursue debt collection in the event
of a mortgage default. In those states,
probability of default is lower and
the forms the default takes are often
quite different from a costly
conventional foreclosure.

The recent surge in residential foreclosures has spurred interest in
the factors that influence whether a borrower will default on his
mortgage. The existing academic literature on the subject usually
assumes that default is mainly a result of a borrower finding himself
with a “negative equity stake” in his home – owing more money on
the mortgage than the house is worth. Even borrowers who do not
experience a change in their income or mortgage payment might
walk away from a home that is “underwater.”
Yet the lender may not be legally able to fully collect the outstanding
debt in such cases. Whether a state allows lenders to pursue “recourse”
– that is, allows them to seize assets other than the home to recover
the debt owed to them – is lost in much of the popular discussion
of the current conditions in the mortgage market. Some states do
allow lenders to cast a wider net when it comes to recouping their
losses from a defaulted mortgage. Other states, such as California
and Arizona, for instance, severely restrict the ability of lenders to
pursue recourse.
Given this, you should naturally expect that the decision of a borrower
to default will be influenced by the ability of the lender to collect on
any outstanding mortgage debt not covered by the proceedings from
the foreclosure sale. Can the high rate of default seen in some states,
then, be at least partly due to the different legal regimes in which
these mortgages reside?
In a July 2009 Richmond Fed working paper, two of the authors of
the present article, Andra Ghent and Marianna Kudlyak, explored
this question.1 As it turns out, the laws of a particular state matter
significantly when it comes to estimating the probability that a
borrower will default on his mortgage. Because the possibility of
lender recourse – often in the form of a “deficiency judgment”
issued by a court – raises the potential cost of default to the debtor,
you should expect this to influence the behavior of the borrower.


The analysis suggests that allowing the lender recourse – and the
more likely that lender is to exercise that right to recourse – lowers
the chances that the borrower will default when he has negative
home equity. In other words, the possibility that a lender can recover
more than the proceeds from the foreclosure sale can deter default.

Finally, in the cases where default does occur, the form it takes may
differ in recourse and non-recourse states.
It is not possible to gauge the effect of lender recourse on the
probability of default simply by observing the number of deficiency
judgments. On the one hand, pursuing a deficiency judgment for a
lender can be a lengthy and expensive process because of costs and
time associated with taking the borrower to court. Thus, seeing few
deficiency judgments pursued may be an indicator of recourse having
no effect on default because lenders simply do not exercise their
right of recourse. On the other hand, observing small numbers of
deficiency judgments in practice may indicate that recourse has a
serious deterrent effect on defaults. In this case, borrowers who have
a lot to lose from lender recourse actually choose not to default –
and, as a result, never show up in the foreclosure numbers.
To answer the question of how best to explain the data, one needs to
compare the default decisions of two borrowers who have identical
equity values in their mortgaged properties, loan-to-value ratios,
credit scores and other observable traits yet reside in states with
different recourse rights for lenders. The analysis described in this
Economic Brief uses this approach – the approach that Ghent and
Kudlyak used in their working paper.
State statutes vary in how much recourse a lender has in the
event that a foreclosure sale of a property is not sufficient to cover
a borrower’s debt. The varying statutes impose different costs on
borrowers and lenders and these costs have a bearing on the behavior
of both parties. In most states, the lender may obtain a deficiency
judgment in court to cover the difference between the balance owed
on the mortgage and the fair market value of the home.
A few states explicitly forbid deficiency judgments on most homes.
Restrictions on the judgments in other recourse states make it highly
impractical and costly for the lender to pursue a court remedy, thereby
making it functionally equivalent to a non-recourse state.2
To help gauge how this influences the behavior of a borrower with
negative equity in his home, assume that a borrower will ascribe a
value to the default option relative to the non-default option. If he
thinks the lender is likely to pursue recourse, this lowers the default
option value. And, as a result, it also lowers the probability of default
given the value of the negative equity in the house.

PAGE 2 EB09-09

By this logic, recourse states would tend to see fewer defaults than
non-recourse states. And that’s just what you see in the data:
The probability of default is 20 percent higher in states with no
recourse when holding other individual loan characteristics constant.3
However, it’s important to note that the effect of recourse on the
probability of default differs for properties with different appraisal
values. Recourse should have a substantial deterrent effect for
properties with higher appraisals. That’s because borrowers with
more expensive homes are likely to be wealthier and thus have
more to lose if the lender pursues a deficiency judgment.
Recourse does more strongly deter default for wealthier borrowers
when the appraised value of the property at origination is used as a
proxy for the borrower’s wealth. For homes appraised at $300,000 to
$500,000, borrowers in non-recourse states are 59 percent more likely
to default than borrowers in recourse states. For homes appraised at
$500,000 to $750,000, borrowers were twice as likely to default.
Mortgages on homes in non-recourse states appraised at $750,000
to $1 million were 66 percent more likely to default.
What if a default does occur? Foreclosure isn’t the only form that it can
take. In fact, lenders typically view litigious foreclosure as a last resort
because it can be costly. They will usually try to recover a portion of
the principle through other means. Furthermore, lenders have a strong
interest in foreclosing quickly on a property as a drawn-out process
can lower the value of the property.
For a borrower, there are a few ways to default: a short sale, a voluntary conveyance (the most common form of which is a “deed-in-lieu”
resolution), agreeing not to contest a foreclosure, or prolonging the
foreclosure process as long as possible. Ghent and Kudlyak find that
the form the default takes will be influenced by whether or not the
mortgaged property is in a recourse state.
In a short sale, the borrower finds a buyer who is willing to purchase
the house for less than the full balance owed on the mortgage. In a
deed-in-lieu resolution, the borrower hands over the deed to the
property to the lender. Finally, a borrower may simply agree to what
is known as a “friendly foreclosure.” In that form of default, the
borrower chooses not to contest the foreclosure and submits to the
court. The main benefit of this option to the lender is that he gets
the property back more quickly relative to a contested foreclosure.
While a friendly foreclosure might take more time and be more costly
than a voluntary conveyance, it is less time-consuming and costly than
a contested foreclosure.

Each of these methods is considered more lender-friendly than a
conventional foreclosure. As a result, lenders will often agree to forgo
the right to a deficiency judgment if the borrower agrees to default
through one of these methods than through a lengthy and contested
process. Thus, a borrower who has a lot to lose from lender recourse
may opt for one of these types of default to keep the lender from
pursuing a deficiency judgment. That’s what the analysis indicates:
When default does occur in the states that allow lenders to
pursue broader recourse, it more frequently occurs in one of the
lender-friendly ways described above. In fact, recourse laws that
favor the lender lower the probability of default through foreclosure
by between 9 percent and 11 percent.


Ghent, Andra C., and Marianna Kudlyak.“Recourse and Residential Mortgage Default: Theory and
Evidence from U.S. States.”Federal Reserve Bank of Richmond Working Paper 09-10, July 2009.


In the analysis, Alaska, Arizona, California, Iowa, Minnesota, Montana, North Carolina (purchase
mortgages), North Dakota, Oregon, Washington, and Wisconsin are regarded as non-recourse states.


This was accomplished by holding the individual loan characteristics at their respective means as
calculated from the sample of defaulted loans at the time of default.

The views expressed in this article are those of the authors and not
necessarily those of the Federal Reserve Bank of Richmond or the Federal
Reserve System.

The sensitivity of the default decision to the legal rules of a particular
state suggests that a non-negligible portion of U.S. mortgage defaults
is in fact strategic – that is, when the borrower decides to actively
walk away from a house that is worth less than the outstanding
balance on the mortgage even if he might be able to continue making
the payments. This contrasts with the popular view that defaults are
driven only by negative shocks to the ability of the borrower to
repay his debt, such as job loss or a cut in income.
In fact, as the analysis described in this Economic Brief suggests, you
do not need to actually observe lenders frequently pursuing deficiency
judgments to see the deterrent effects. The fact that lenders have the
ability to pursue recourse at all encourages borrowers to think hard
about defaulting and, if they do default, what form that default might
take. Thus, the ability of lenders to minimize their losses in each state
must be considered in any analysis that seeks to discover why some
borrowers default and others do not.

Andra C. Ghent is an assistant professor of real estate at Baruch
College, City university of new york. Marianna Kudlyak is an
economist at the Federal Reserve Bank of Richmond. Stephen
Slivinski is senior editor of the Richmond Fed’s quarterly
magazine, Region Focus.

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