Foreclosure Contagion and the Neighborhood Spillover Effects of Mortgage Defaults

I analyze the existence of default spillovers in the residential mortgage market. I exploit within-month variation in interest rates resulting from two administrative details in ARM contract terms: the choices of financial index and lookback period. I find that a 1 percentage point increase in interest rates at the time of ARM reset results in a 2.5 percentage rise in the probability of foreclosure in the following year. Instrumenting for mortgage foreclosure using these reset characteristics, I find evidence that each completed foreclosure leads to an additional 0.3 to 0.6 filings within a 0.10 mile radius. I document that price effects of foreclosures on neighboring home prices are unlikely to completely account for the magnitude of this effect. Complementing the price channel, I emphasize two mechanisms: a bank-supply channel resulting in a one-third drop in refinancing activity after a foreclosure, and a borrower response channel arising from peer effects. I document that neighboring borrower payment responses are  linked to the timing of local mortgage default, are not associated with defaults on revolving debts, and are concentrated in areas with few nearby local foreclosures---consistent with an information channel based on learning about the costs of default. I also provide suggestive evidence on the macroeconomic impact of foreclosure spillovers: I find that counties and zip codes experiencing greater intensity of reset among borrowers in adverse conditions experience subsequent drops in house prices and higher foreclosure volumes. These results shed light on an important amplification channel of shock transmission during the recent foreclosure crisis.