The rise in "underwater mortgages"--roughly understood as when the principal owed on a house exceeds its market value--has been widely reported.  But these maps from the Federal Reserve Bank of San Francisco highlight the change.  Here's the share of underwater mortgages, state-by-state, in 2000:

Now look at the underwater rates for the fourth quarter of 2009:

These maps are from the latest Economic Letter, in which John Krainer, senior economist at the San Francisco Fed, and Stephen LeRoy, a visiting scholar there, examine the relationship between house prices and default rates.  When housing prices drop and a mortgage is underwater, that does not, they say, mark the point where it is in the borrower's best interest to default:

At what point does it serve a borrower’s rational interest to default? A handy rule of thumb is to use the underwater threshold at which the outstanding loan balance equals the house’s market value as the location of the default point. However, that underwater point is not consistent with rational behavior on the part of the borrower (see Merton 1974 and Krainer, LeRoy, and O 2009). To understand why, consider a homeowner who is at the underwater point, with the house value exactly equal to the outstanding balance of the mortgage. Should this borrower strategically default? We argue that the borrower still has incentive to stay in the house. Going forward, the borrower is in a “heads-I-win, tails-you-lose” position vis-à-vis the lender. If house prices fall further, then the borrower can default immediately, so that declines in house prices translate into losses for the lender. On the other hand, if house prices rise, then the gain accrues to the borrower. With no downside risk, the borrower will not actually be indifferent as to whether to default. Contrary to what many might assume, the borrower will actively prefer not to default. With both upside potential and downside protection against future losses, the borrower rationally should wait before defaulting.

The observation that homeowners will not rationally default as soon as they fall underwater on their mortgages has some powerful implications. First, even though the borrower apparently has no equity in the house because house value is equal to the amount owed on the mortgage, the borrower behaves as though equity were positive by not defaulting. The borrower does not default because the decision to do so is not based on the book, or accounting, value of the homeowner equity, which is zero. Instead, it is based on the economic or “market value” of the equity, which remains positive.

Second, the fact that homeowners distinguish between market and book values of their homeowner equity implies that they also distinguish between the market and book values of their mortgages. This is a simple relationship based on household balance sheet identity. The value of a homeowner’s assets (in this case the house) must equal the sum of liabilities (in this case the mortgage) plus the homeowner’s equity. The big difference between the market and book value concepts for mortgage valuation is that the market value of a mortgage depends on house prices while the book value of the mortgage does not. Based on market value, the default point is the house price at which the benefits and costs of staying are exactly matched by the benefits and costs of leaving. Put another way, the homeowner defaults when the market, not the book, value of equity is equal to zero or, equivalently, when the market value of the house is equal to the market value of the mortgage liability. The default point calculated this way is always lower than that based on book value, sometimes by a wide margin.

Read Underwater Mortgages here.