Underwater Homeowners Unable to Swim to Warmer Waters?

02/01/2011 06:04 pm ET | Updated May 25, 2011

Imagine this: You're a successful professional in a small city, circa 2005. Your job is going well and the housing market is going gangbusters, so you dive in and buy a great starter home. You put down 10 percent (a lot for the times) and take out a 30-year fixed loan with monthly payments you can easily afford. You are responsible.

Fast forward a few years, and the Great Recession is underway. Your company is in trouble, and you get laid off.

Since you bought near the peak of the market and only put down 10 percent, you owe more on your mortgage than your home is worth. You're underwater, like more than one in five single-family homeowners with mortgages, according to my real estate research firm Zillow.

You've got enough in savings to get by for a few months, and you start searching for a job. Your area has been hard-hit by unemployment, so you're thrilled when you get an offer from across the country. One problem: You're stuck in your home. Or are you?

The idea that negative equity impacts labor mobility is a notion that has likely occurred to anybody who's thought about the matter for more than a couple minutes. Our acceptance of this notion is aided by a constellation of facts that seems to support it:

1. Long-term unemployment, measured as the percentage of unemployed people who have been out of work for more than 27 weeks, is at its highest level (44.3%) ever seen in the data series stretching back to the late 1940s. An interesting phenomenon considering that while unemployment itself is high (9.4% currently), it has been higher in the past (10.8% in November 1982).

2. Labor mobility is quite low. Only 1.4% of Americans moved between states in the year ending March 2010, the lowest interstate migration rate in the past fifty years. Moreover, interstate migration encountered a sharp decline in 2006, the year in which home values crested and started to fall.

3. The housing recession that began in 2006 and has already led to a decline of more than 26% in the value of homes (assuming they are sold in a non-distressed transaction) has created rates of negative equity that are unprecedented in the post Great Depression era. At the end of the third quarter of 2010, Zillow estimated that 23.2% of single-family homes with a mortgage were in a negative equity position.

So, the data appear incontrovertible: high negative equity has led to decreased mobility which, in turn, has led to higher-than-normal long-term unemployment. The icing on the cake? A report in 2008 from the New York Fed confirming this relationship in a direct empirical test. Mobility was almost 50 percent lower for owners with negative equity than owners with positive equity. Slam dunk, right?

Revised Data Throws Cold Water on Relocation Theory

As with many complex economic problems, jumping to conclusions is not so simple. Late last year, the Minneapolis Fed released a couple papers that threw cold water on the whole argument. First came a paper arguing that migration between states actually didn't suffer a precipitous decline in 2006. What happened instead is that the Census Bureau, who collects the data to compute the metric, changed their method of accounting for missing data (when respondents can't or won't answer a question). Once correcting for the change in methodology, it turns out that interstate migration has been on a slow, steady decline since 1996 and there was no actual blip in 2006. The reasons behind this longer term decline are the focus of active, ongoing research into whether mobility has become less necessary or simply harder and more expensive.

Second came the paper taking another look at the New York Fed analysis and showing that the original authors' treatment of missing data had biased the results. Reproducing the analysis with the change in the treatment of missing data found that homeowners with negative equity are at least as mobile as those with positive equity, and that those with high levels of negative equity are particularly mobile. Theoretically, this latter conclusion makes some sense for an underwater homeowner since the upside of moving (by defaulting and getting into a cheaper housing situation) grows relative to the downside (taking a credit hit because of foreclosure) as the level of negative equity grows. (Interesting side note: a senior economist at the Minneapolis Fed, Sam Schulhofer-Wohl, was author on both papers; Greg Kaplan at the University of Pennsylvania was co-author on the first).

In conclusion, negative equity is toxic in a lot of ways. It combines with unemployment to increase the foreclosure rate which, in turn, depresses home values. It also slows the conveyor belt of homeowners selling their current homes and buying up to more expensive ones because they can't easily sell due to negative equity. But, as markets continue to experience declines in home values towards what Zillow hopes is a bottom later this year, it is at least somewhat comforting that negative equity doesn't appear to be leading to stasis in our labor market. We'll take good news wherever we can find it.