Trading Equity for Liquidity:

Bank Data on the Relationship Between Liquidity and Mortgage Default

June 2019

Diana Farrell, Kanav Bhagat, and Chen Zhao

June 2019

For many, homeownership is a vital part of the American dream. Buying a home represents one of the largest lifetime expenditures for most homeowners, and the mortgage has generally become the financing instrument of choice. For many families, their mortgage will be their greatest debt and their mortgage payment will be their largest recurring monthly expense.

In this report, we present a combination of new analysis and previous findings from the JPMorgan Chase Institute body of housing finance research to answer important questions about the role of liquidity, equity, income levels, and payment burden as determinants of mortgage default. Our analysis suggests that liquidity may have been a more important predictor of mortgage default than equity, income level, or payment burden.

We find:

  • Finding 1: Borrowers with little post-closing liquidity defaulted at a considerably higher rate than borrowers with at least three mortgage payment equivalents of post-closing liquidity.
  • Finding 2: Borrowers with little liquidity but more equity defaulted at considerably higher rates than borrowers with more liquidity but less equity.
  • Finding 3: Default closely followed a loss of liquidity regardless of the homeowner’s equity, income level, or payment burden.
  • Finding 4: Homeowners with fewer than three mortgage payment equivalents of liquidity defaulted at higher rates regardless of income level or payment burden.
  • Finding 5: Mortgage modifications that increased borrower liquidity reduced default rates, whereas modifications that increased borrower equity but left them underwater did not impact default rates.

Taken together, our findings suggest that a program encouraging borrowers to make a slightly smaller down payment and use the residual cash to fund an “emergency mortgage reserve” account might lead to lower default rates. A pilot program could test the impact of an emergency mortgage reserve account on default rates and, if impactful and cost-effective, the program could serve as an alternative to underwriting standards based on measuring the borrower’s static ability-to-repay using their total debt-to-income ratio at origination.

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