When America spun into the recession the default rate on mortgages also spiraled up from traditional norms of 0 to 2 percent to as high as 10 percent of all mortgages and in some markets and for certain loans, over 25 percent.

While default allowed many borrowers to get out from under heavy housing costs and others to escape from mortgages that were underwater, default is far from positive for most borrowers and many perceive it to be very costly, losing equity and access to credit.  There has not been much research into these costs however, so the most recent Economic Letter from the Federal Reserve Bank of San Francisco looks at how long it takes persons or households that default on a mortgage to return to home ownership.

William Hedberg, a research associate and John Krainer a senior economist at the bank looked at Equifax's consumer loan data from the first quarter of 1999 to the fourth quarter of 2011, defining a mortgage default as one that was either 120 days past due or marked "severely derogatory" meaning past due and with a charge-off or foreclosure.  They then looked at when those borrowers again had access to credit.  The researchers did not attempt to determine if the borrower might not desire credit nor did they differentiate between lender decisions about granting credit and institutional restrictions such as those put in place by the government sponsored enterprises (GSEs) that do not preclude but put up a powerful barriers to returning to the market.

The data show that a prior mortgage default has a large effect on future access to mortgage credit.  Figure 1 shows the rate at which borrowers with different credit histories return to the mortgage market after they exited it.  Those who had a zero mortgage balance after having a positive one (whether through amortization, trading up, or moving) without a default return to the market at a highly accelerated rate compared to those who exited through a default.  While some non-defaulters like those who have paid off their mortgages might never return to the market, the study found that 35 percent had taken out new mortgages within the 12 years covered by the study while only about 15 percent had returned to the market after a default.

Figure 2 shows the rates at which borrowers who defaulted on mortgages in 2001, 2003, or 2008 returned to the market. The figure plots the cumulative percentage of defaulters who have a new mortgage within a given number of quarters after their last default. Even though a short amount of time has passed since the 2008 cohort defaulted, their return to the housing market appears to be significantly slower than for cohorts that defaulted in the two earlier years. The low rate of return for the 2008 cohort could be related to demand. In the 2001 and 2003 cohorts, there was very strong overall demand for housing, as evidenced by the strong run-up in the rate of homeownership during the 2000s. But the Great Recession that began in 2007 was much deeper than the 2001 recession, and uncertainty about jobs or future income prospects may have made people unwilling or unable to demand housing at the rate seen after previous recessions.

The slow return evidenced in the group that defaulted in 2008 (and 2009 and 2010 cohorts which look very similar) could also reflect the tight credit supply.  The credit environment for the 2001 and 2003 cohorts was very different in the years after their defaults. Loan terms were generally easy and subprime mortgage lending boomed.  The economic picture was much brighter in the earlier period as well, but even in the good times of 2001 and 2003 it took a long time for borrowers to return to the housing market after default and about two-thirds of the 2001 group had still not done so after ten years.

Figure 3 looks at defaulted borrowers by credit score using borrowers' first scores after taking out the loans on which they ultimately defaulted.  Borrowers with the higher scores are labeled as prime borrowers by the authors and the lower score borrowers as subprime.

The two groups in the years immediately following foreclosure had similar experiences, probably because the prime borrowers were no longer prime; their credit scores had been badly damaged.  But after about two years the prime borrowers began to return as a far faster rate than those that were subprime even though the majority of prime borrowers did not return during the study period.

The authors expected there might be a distinction in their study between borrowers who defaulted in judicial or in non-judicial foreclosure states because the judicial foreclosures are most costly and time consuming.  All else being equal, they say, borrowers in judicial states would be expected to be denied credit for longer periods.  While there was a distinction, it was not large.

What explains the low return of defaulted borrowers to the market?  The authors found that overall economic conditions such as local unemployment rates and past house appreciation appear to play an important role, but the best predictor was the change in the borrowers' credit score.  The research found that, after five years, borrowers who return to the mortgage market after a default have experienced a more-than-100 point increase in their score.

In conclusion Hedberg and Krainer say that the process of regaining creditworthiness is lengthy. Borrowers who terminated their mortgages for reasons other than default returned to the market about two-and-a-half times faster than those who defaulted. "This has important implications for the housing recovery. The improvement in the housing market is often assumed to reflect significant pent-up demand. But an estimated 4 million foreclosures have taken place since 2007. The consumers who went through those foreclosures will return to homeownership only gradually, suggesting that mortgage supply will also be a factor in the housing recovery."