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Journal Article•DOI•

Negative Equity and Foreclosure: Theory and Evidence

Christopher L. Foote1, Kristopher Gerardi2, Paul S. Willen1, Paul S. Willen3•
Federal Reserve Bank of Boston1, Federal Reserve Bank of Atlanta2, National Bureau of Economic Research3
05 Jun 2008-Social Science Research Network-
TL;DR: In this article, the authors examine more than 100,000 homeowners in Massachusetts who had negative equity during the early 1990s and find that fewer than 10 percent of these owners eventually lost their home to foreclosure.
Abstract: Millions of Americans have negative housing equity, meaning that the outstanding balance on their mortgage exceeds their home's current market value. Our data show that the overwhelming majority of these households will not lose their homes. Our finding is consistent with historical evidence: we examine more than 100,000 homeowners in Massachusetts who had negative equity during the early 1990s and find that fewer than 10 percent of these owners eventually lost their home to foreclosure. This result is also, contrary to popular belief, completely consistent with economic theory, which predicts that from the borrower's perspective, negative equity is a necessary but not a sufficient condition for foreclosure. Our findings imply that lenders and policymakers face a serious information problem in trying to help borrowers with negative equity, because it is difficult to determine which borrowers actually require help in order to prevent the loss of their homes to foreclosure.

Summary (4 min read)

Jump to: [1 Introduction] – [2 Homeowners with negative equity] – [2.1 Massachusetts Registry of Deeds data] – [2.2 Negative equity exercise] – [2.2.1 Borrowers with negative equity in 1991 and 2007] – [2.2.2 A duration model of ownership termination] – [2.2.3 Results from the model] – [3 The basic economics of default from the bor-] – [4 Lenders, loss mitigation, and incomplete infor-] – [5 Analyzing foreclosure prevention proposals] – [5.1 Modification plans] – [5.3 Expanded forbearance] and [6 Conclusions]

1 Introduction

  • As a consequence of the recent nationwide fall in house prices, many American families othe authors more on their home mortgages than their houses are worth—a situation known as “negative equity.”.
  • Because the authors observe the price of each home purchased, the size of all purchase loans, and the subsequent behavior of housing prices, they are able to construct a rough proxy of housing equity for each Massachusetts homeowner who purchased a home on or after January 1987.
  • Thus, the authors argue that negative equity does play a key role in the prevalence of foreclosures, but not because (as is commonly assumed) it is optimal for borrowers with negative equity to walk away from affordable mortgages.
  • In other words, the costs of forgone income from borrowers who would have made payments often exceeds the benefits of fewer foreclosures.
  • The second policy is “forbearance,” in which the borrower receives only a temporary reduction of the monthly mortgage payment, with the stipulation that this benefit is repaid, with interest, at a later date.

2 Homeowners with negative equity

  • The authors use a unique historical dataset of mortgages and house values in Massachusetts, encompassing two housing downturns, to identify and track borrowers who are likely to be in positions of negative equity.
  • The authors first study the experiences of borrowers with negative equity during the state’s previous housing downturn in the early 1990s.
  • The authors payments of the mortgage the “lender.” 4In addition, a forbearance policy may be much more appealing from an institutional standpoint, as forbearance does not violate any of the rules of the mortgage backed security (MBS) agreements, and thus servicers are able to implement such a policy at their own discretion.
  • The institutional frictions that may hinder certain loss-mitigation policies are beyond the scope of this paper.

2.1 Massachusetts Registry of Deeds data

  • In this section the authors briefly describe the data and the model that they use for their foreclosure and negative equity calculations.
  • For further details, the authors direct the reader to Gerardi, Shapiro, and Willen (2007), hereafter referred to as GSW.
  • These data include information on virtually all residential mortgage and housing transactions, including foreclosure deeds, registered in the state over the past 20 years.
  • Using these house price indexes and initial LTV ratios, the authors are able to calculate a negative equity proxy for each borrower in the data.
  • A foreclosure deed signifies the very end of the foreclosure process, when a property is sold at auction, either to a private bidder, or to the lender, at which point the property status becomes real-estate owned (REO).

2.2 Negative equity exercise

  • In this section the authors estimate the percentage of Massachusetts homeowners who are currently in a position of negative equity (as of 2007:Q4) and who will default on their mortgage and experience a foreclosure over the next three years.
  • The authors believe that this is an important calculation, as it provides an upper bound for the percentage of borrowers whom policymakers can hope to help avoid the foreclosure process.
  • The authors break this section into three subsections.
  • In 2.2.1 the authors discuss the experiences of borrowers with negative equity in the last housing downturn, focusing on 1991:Q4, and also document the number of negative equity borrowers as of 2007:Q4.
  • Finally, in 2.2.3 the authors present the results of their foreclosure simulations.

2.2.1 Borrowers with negative equity in 1991 and 2007

  • Massachusetts experienced a significant housing downturn in the early 1990s that coincided with a national recession that was especially severe in New England.
  • The first column in Table 1 contains summary statistics regarding the number of borrowers with negative equity at the end of 1991, and the number of subsequent foreclosures experienced by these borrowers.
  • Again, this number captures only mortgage borrowers who purchased homes on or after January 1, 1987.
  • Thus, the authors may expect a higher percentage of borrowers with negative equity in 2007 to subsequently default on their mortgages, compared with negative equity borrowers in the early 1990s.

2.2.2 A duration model of ownership termination

  • In this section the authors briefly describe the main properties of the model.
  • As discussed above, the equity calculation does not take into account amortization of the mortgage, or refinancing activity.

2.2.3 Results from the model

  • Using the duration model, the authors can forecast the number of foreclosures that these negative equity borrowers will experience over the period 2008–2010.
  • In the bottom panel of Table 4, the authors display the effects of these changes on the level of the conditional default hazard for ownerships that have aged five years.
  • Finally, in the third scenario,, the authors assume that house prices will first decline substantially and bottom out after one year, and then increase over the following two years.
  • Finally in the third scenario, the model predicts that about 7.5 percent (7,050 households) of the borrowers with negative equity will default on their mortgages.

3 The basic economics of default from the bor-

  • Rower’s perspective Economic theory poses one categorical prediction about the relationship between negative equity and default, which is that negative equity is a necessary condition for default.
  • The authors assume that the borrower either sells the home in the second period or defaults on the mortgage.
  • A common explanation of this finding, advocated in the literature (see Stanton, 1995, for example), is that significant transactions costs are associated with defaulting, and these transactions costs differ across borrowers.
  • 24The term “cost of funds” refers to the interest rate at which a given household or individual can borrow.
  • The authors have shown that even with negative equity, defaulting on a mortgage can have negative net present value — the benefits of reduced obligations do not outweigh the costs of reduced income.

4 Lenders, loss mitigation, and incomplete infor-

  • The authors look at the lender’s decision to offer loss mitigation options to the borrower.
  • The lender has an outstanding loan and the value of that loan, conditional on the borrower not defaulting, is m.
  • The reduction in the value of the mortgage cannot exceed the loss given foreclosure times the probability of foreclosure associated with the borrower receiving loss mitigation.
  • To illustrate the importance of accurately identifying at-risk borrowers, the authors first consider a simple plan in which lenders agree to write down debt for any borrower with negative equity.
  • Policymakers are clearly aware of this problem and they have come up with several fixes.

5 Analyzing foreclosure prevention proposals

  • Loss mitigation schemes face a daunting set of constraints.
  • For borrowers, this means that the scheme must reduce the value of the mortgage relative to the value of the house (equation (7)).
  • To be attractive to the lender, loss mitigation must increase expected loan recovery (so equation (9) must exceed (8)).
  • Forbearance, on the other hand, involves a lender temporarily agreeing to accept lower payments, without changing any of the original terms of the loan.
  • Many of the public policy proposals to address the foreclosure crisis employ either modification or forbearance or some combination of the two.

5.1 Modification plans

  • Loan modification plans are attractive to virtually all borrowers.
  • Appreciating America is a proposal designed by Nicholas Bratsafolis, Chairman and CEO of Refinance.com.
  • Lenders and policymakers would have a very difficult time distinguishing between cases in which the borrower’s DTI ratio falls because of a legitimate, unexpected income shock (such as job loss), and cases in which the borrower manipulates his or her income or debt levels in order to qualify for mitigation.
  • The issue of moral hazard could be solved by limiting assistance to borrowers who had a DTI ratio above a certain level at the time of mortgage origination, or in the period before the plan was introduced.
  • Furthermore, the authors argue elsewhere [Foote, Gerardi, Goette, and Willen (2008)] that there is little evidence that the resets of adjustable rate mortgages cause systematic delinquency or foreclosure.

5.3 Expanded forbearance

  • Several recent public policy proposals offer borrowers an option that basically amounts to forbearance.
  • The plans differ significantly in the details, so in this section the authors will focus on a stylized plan, which captures the basic features of all of these plans.30.
  • These additions to forbearance may be appealing from a public policy perspective because these features increase the attractiveness of a forbearance policy to both lenders and borrowers.

6 Conclusions

  • The initial key conclusions of this paper can be summed up in two statements which, at first blush, appear contradictory.
  • The first statement reflects the necessity of negative equity for foreclosure—borrowers with positive housing equity will sell if they need to move.
  • The second statement addresses the fact that the default decision involves weighing the payments on the mortgage against the income, imputed or actual, that accrues from retaining ownership of the house.
  • The second important set of conclusions follows from the first, by illustrating that policy responses need not, and probably cannot, address the negative equity problem directly.
  • Forbearance programs that allow borrowers to delay, but not to avoid eventually repaying the mortgage in full can help at-risk borrowers without generating serious moral hazard problems, involving assistance, funded at the public’s expense, to those who do not need it.

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Content maybe subject to copyright    Report

No.08‐3
NegativeEquityandForeclosure:
TheoryandEvidence
ChristopherL.Foote,KristopherGerardi,andPaulS.Willen
Abstract:
MillionsofAmericanshavenegativehousingequity,meaningthattheoutstandingbalanceon
their mortgage exceeds their home’s current market value. Our data show that the
overwhelming majority of these households will not lose their homes. Our finding is
consistent with historical evidence: we examine more than 100,000 homeowners in
Massachusetts who had negative equity during the early 1990s and find that fewer than 10
percentoftheseownerseventuallylosttheirhometoforeclosure.Thisresultisalso,contrary
to popular belief, completely consistent with economic theory, which predicts that from the
borrower’s perspective, negative equity is a necessary but not a sufficient condition for
foreclosure. Our findings imply that lenders and policymakers face a serious information
problemin tryingtohelpborrowerswithnegative equity,becauseitisdifficulttodetermine
which borrowers actually require help in order to prevent the loss of their homes to
foreclosure.
JELClassifications:D11,D12,G21,R20
ChristopherL.FooteandPaulS.WillenaresenioreconomistsandpolicyadvisorsandKristopherGerardiisa
researchassociateattheFederalReserveBankofBoston.GerardiwilljointheFederalReserveBankofAtlantain
Septemberasaresearcheconomist.Theiremailaddressesarechris.foote@bos.frb.org
,paul.willen@bos.frb.org,and
kristopher.gerardi@bos.frb.org
respectively.
We thank TimWarren and AlanPasnikof The WarrenGroup, andDick Howe Jr.,theRegister of Deeds of North
MiddlesexCounty,Massachusetts,for providing uswithdata,advice, andinsight.Wealsothank Elizabeth Murry
forprovidinghelpfulcommentsandedits.
Thispaper,whichmayberevised,isavailableonthewebsiteoftheFederalReserveBankofBostonat
http://www.bos.frb.org/economic/ppdp/2008/ppdp0803.htm
.
The views expressed inthis paper are solely thoseof theauthors and not necessarilythose ofthe Federal Reserve
BankofBostonortheFederalReserveSystem.
Thisversion:June5,2008
1 Introductio n
As a consequence of the r ecent nationwide fall in house prices, many American families
owe more on their home mortgages than their houses are worth—a situation known
as “negative equity.” The effect of negative equity on the national foreclosure rate is
of obvious interest to policymakers, but this effect is difficult to study with datasets
that are commonly used in housing research. In this paper, we exploit unique data
from the Massachusetts housing market t o make three points. First, during a specific
historical episode involving a downturn in housing prices—Massachusetts during the
early 1990s—less than 10 percent of a group of homeowners likely to have had negative
equity eventually defaulted on their mortgages. Thus, current f ears that a large
majority of today’s homeowners in negative equity positions will soon “walk away”
from their mortgages are probably exaggerated. Second, we show that this failure to
default en masse is entirely consistent with economic theory. The failure does not
need to be explained by fa ctors such as sentimental attachment to homes, moving
costs, or the stigma attached to mortgage default. Third, we show that our empirical
and theoretical findings have import ant implications for current proposals designed
to address the negative-equity issue and prevent foreclosures. These implications
hinge on the incentive problems that arise when lenders cannot distinguish which
homeowners with negative equity need help to avoid foreclosure and which ones do
not.
Previous analyses of negative equity has been hindered by the lack of data on the
complete ownership experiences of individual homeowners. We use data from Massa-
chusetts Registry of Deeds offices that allow us to track every residential mortg age
origination and house purchase in Massachusetts starting in January 1987. Because
we observe the price of each home purchased, the size of all purchase loans, a nd the
subsequent behavior of housing prices, we are able to construct a r ough proxy of
housing equity for each Massachusetts homeowner who purchased a home on or after
January 1987. The deeds data also allow us to track the eventual outcome of each
homeowner. Specifically, we can tell whether any particular homeowner eventually
defaulted and experienced a foreclosure. The specific gro up of borrowers we study in
this paper is the set of all post-1986 purchasers who were likely to have had negative
equity in 1991:Q4, a time that we believe is comparable to the current situation in the
housing cycle.
1
We find that of the 100,3 00 borrowers we identify as having negative
equity in 1991 :Q4, only 6 ,450 actually lost their homes to foreclosure over the next 3
1
In both 1991 and 2007, house prices had fallen during the previous two years. Furthermore,
after 1991, prices continued falling for another two years, which is consistent with some current
forecasts as of May 2008.
2
years. The Massachusetts data also allow us to estimate the incidence of future mort-
gage defaults. Specifically, we can identify 94,600 borrowers with negative housing
equity in 2007:Q4. Using an econometric model of foreclosures estimated using the
Massachusetts data, we predict that between 6 ,5 00 and 7,600 of these borrowers will
lose their homes to foreclosure by the end of 2 010. This prediction assumes no policy
changes that would modify loan terms, either temporary, or permanently, but it does
depend on various macroeconomic conditions and house price outcomes.
To some, the fact that so few borrowers with negative equity actually default
will sound odd. Why would borrowers continue to make payments on houses that are
worth less than their mortgag es? In reality, there typically are good economic reasons
for doing so. From a borrower’s persp ective, the decision to default hinges on how
onerous the monthly mortgage payment is, relative to the possibility that the house’s
value will eventually exceed the balance on the mortgage. Some borrowers with
negative equity have little liquid wealth and/or high expenses. For these borrowers,
the decision often tilts toward default as the economically rational outcome. But
borrowers with negative equity that have ample liquid wealth will usually find it in
their economic interest to stay in their homes.
Understanding these t heoretical and practical impacts upon the foreclosure deci-
sion helps us understand the true role negative equity plays in the borrower’s choice of
whether or not to default. A foreclosure requires both negative equity and a household-
level cash-flow problem tha t makes the monthly mortgage payment unaffordable to
the borrower. Cash-flow problems without widespread negative equity do not cause
foreclosure waves.
2
Even if bo r rowers are having trouble making payments, they will
always prefer to sell their homes rather than default, as long as equity in their homes
is positive so they can pay off their outstanding mortg age balances with the proceeds
of the sales. Similarly, widespread negative equity will not result in a foreclosure
boom in the absence of cash-flow problems. Borrowers with negative equity and a
stable stream of income will, in most cases, prefer to continue making mortgage pay-
ments. Thus, we argue that negative equity does play a key role in the prevalence of
foreclosures, but not because (as is commonly assumed) it is optimal for borrowers
with negative equity to wa lk away from affo r dable mortgages.
These findings have important implications for how lenders address widespread
negative equity among t heir borrowers. Lenders often attempt to mitigate foreclosure-
related losses by extending assistance to borrowers, but in doing so, they face an in-
complete information problem.
3
To lenders, the cost of an assistance policy depends
2
The 2001 U.S. recession is a good example.
3
In the remainder of this pa per we refer to the party that is entitled to the interest and principal
3
on how many borrowers qualify for assistance (that is, how many borrowers are cur-
rently in a position of negative equity). The benefits of an assistance policy depends,
in part, on the fraction of borrowers that truly need a ssistance ( tha t is, how many
borrowers with negative equity will default if no assistance is given). Our empirical
and theoretical results imply that the number of borrowers who would qualify for an
assistance policy can be fa r greater than the number of borrowers who truly need
help. In other words, the costs of forg one income from borrowers who would have
made payments often exceeds the benefits of fewer foreclosures.
We apply these lessons to two common loss-mitigation strategies sometimes offered
by lenders. The first strategy is “loan modification,” in which the t erms of the loan
(such as the outstanding balance, or the interest rate) are permanently adjusted
to the advantage of the borrower. The second policy is “forbearance,” in which the
borrower receives only a temporary reduction of the mont hly mortga ge payment, with
the stipulation that this benefit is repaid, with interest, at a later date. We show that
the incomplete information problem discussed above is particularly severe for loan-
modification policies, because these plans are attractive to virtually all borrowers,
not just those who are in danger o f f oreclosure. In contrast, borrowers who do not
need help are unlikely to find forbearance attractive, because this policy alters only
the timing of repayment, not how much is owed. Because forbearance does not suffer
from the same moral hazard problem as loan modification, the costs of a forbearance
policy turn out to be significantly lower.
4
2 Homeowners with negative equity
We use a unique historical dataset of mortgages and house values in Massachusetts,
encompassing two housing downturns, to identify and track borrowers who are likely
to be in positions of negative equity. We first study the experiences of bo rr owers with
negative equity during the state’s previous housing downturn in the early 19 90s. We
payments of the mo rtgage the “lender.” Thus, this term refers to both a mortgage lender that keeps
loans in its own portfolio, as well as an investor in mortgage-backed se c urities (MBS).
4
In addition, a forbearance policy may be much more appealing from an institutional standpoint,
as forbearance does not violate any of the rules of the mortgage backed sec urity (MBS) agreements,
and thus s e rvicers are able to implement such a policy at their own discretion. Modifications, on the
other hand, alter the terms of mortgage contracts, and thus may violate the terms of MBS agreements
in certain cases. The institutional frictions that may hinder cer tain loss-mitigation policies are
beyond the scope of this paper. However, our conversations with industry experts suggest that they
may play a very importa nt role in the ultimate success or failure of many foreclosure prevention
policies, and thus are an important topic for future research.
4
then use a duration model estimated on Massachusetts data t o predict the eventual
foreclosures of borrowers with negative equity as o f 2007:Q4.
2.1 Massachusetts Registry of Deeds d ata
In this section we briefly descr ibe the data and the model that we use for o ur for e-
closure and negative equity calculations. For further details, we direct the r eader to
Gerardi, Shapiro, and Willen (2007), hereafter referred to as GSW.
We use data purchased from the Warren Group that come from Massachusetts
county-level, Registry of Deeds offices. These dat a include information o n virtually all
residential mortgage and housing transactions, including foreclosure deeds, registered
in the state over the past 20 years. The Warren Group has also calculated a set of
property identifiers in the data that allow us to track the same residential property
over time. Using this information, we are able to identify consecutive purchase deeds
on the same house, and all of the mortgages originated in the time-span between
the deeds. We call this time-span an “ownership experience,” as it corresponds to
the period during which a household occupies a particular home. The data include
the dates and nominal amounts of housing purchases and sales, as well a s mortgage
originations. Thus, we are able to calculate a precise loan-to-value (LTV) ratio at the
time of purchase [for each borrower in the data]. These LTV ratios are cumulative in
the sense that these include all mortga ges taken out at the t ime of purchase, including
“piggyback” or second (and even third) mortgages.
We also use the data to construct house price series. Specifically, the ability
to identify consecutive purchase deeds for the same property allows us to calculate
house price indexes at a fairly disaggregated level using the Case-Shiller repeat-sales
methodology. We are able to calculate more than 100 house price indexes for the 350
towns and cities in Massachusetts.
5
Using these house price indexes and initial LTV ratios, we are able to calculate
a negative equity proxy for each bo r rower in the data. We for m an estimate, E
it
,
that corresponds to the amount of equity that borrower i has at time t, based on the
initial LTV rat io , and the amount of cumulative house price appreciation experienced
in the town where the borrower has resided since the date of purchase:
E
it
= (1 − LT V
i
) + C
HP A
jt
, (1)
where C
HP A
jt
corresponds to the cumulative amount of house price appreciation ex-
perienced in town j from the date of house purchase through time t.
5
We are able to calculate price indexes fo r the lar ger towns and cities in Massachusetts, but in
order to obtain precise indexes, we were forced to combine many of the state’s smaller towns.
5
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Abstract: Today's financial regulatory systems assume that regulations which make individual banks safe also make the financial system safe. The eleventh Geneva Report on the World Economy shows that this thinking is flawed. Actions that banks take to make themselves safer can - in times of crisis - undermine the system's stability. The Report argues for a different approach. What is needed is micro-prudential (i.e. bank-level) regulation, macro-prudential (i.e. system-wide) regulation, and careful coordination of the two. Macro-prudential regulation in particular needs reform to ensure it countervails the natural decline in measured risk during booms and its rise in subsequent collapses. "Counter-cyclical capital charges" are the way forward; regulators should adjust capital adequacy requirements over the cycle by two multiples - the first related to above-average growth of credit expansion and leverage, the second related to the mismatch in the maturity of assets and liabilities. Changes to mark-to-market procedures are also needed. Macro- and micro-prudential regulation should be carried out by separate institutions since they differ in focus and expertise required. Central Banks should be tasked with macro-prudential regulation, Financial Services Authorities with micro-prudential regulation. Improved international coordination is also important. Since financial and asset-price cycles differ from country to country, counter-cyclical regulatory policy needs to be implemented mainly by the "host" rather than the "home" country.

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  • ...triggered a wave of mortgage defaults and home foreclosures, perhaps because some borrowers did not fully understand the terms of their mortgage contract (Bucks and Pence, 2008) or perhaps because a significant portion of homeowners chose to strategically default once their mortgage was sufficiently under water (Haughwout et al., 2008; Foote et al., 2008)....

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Abstract: We use survey data to study American households’ propensity to default when the value of their mortgage exceeds the value of their house even if they can afford to pay their mortgage (strategic default). We find that 26% of the existing defaults are strategic. We also find that no household would default if the equity shortfall is less than 10% of the value of the house. Yet, 17% of households would default, even if they can afford to pay their mortgage, when the equity shortfall reaches 50% of the value of their house. Besides relocation costs, the most important variables in predicting strategic default are moral and social considerations. Ceteris paribus, people who consider it immoral to default are 77% less likely to declare their intention to do so, while people who know someone who defaulted are 82% more likely to declare their intention to do so. The willingness to default increases nonlinearly with the proportion of foreclosures in the same ZIP code. That moral attitudes toward default do not change with the percentage of foreclosures in the area suggests that the correlation between willingness to default and percentage of foreclosures is likely to derive from a contagion effect that reduces the social stigma associated with default as defaults become more common.

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TL;DR: In this article, the authors quantify the effect of recourse on default and find that recourse affects default by lowering the borrower's sensitivity to negative equity, and that defaults are more likely to occur through a lender-friendly procedure, such as a deed in lieu, in states that allow deficiency judgments.
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Mortgage terminations, heterogeneity and the exercise of mortgage options

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Yongheng Deng1, John M. Quigley2, Robert Van Order1•
University of Southern California1, University of California, Berkeley2
01 Mar 2000-Econometrica
TL;DR: In this article, the authors present a unified model of the competing risks of mortgage termination by prepayment and default, considering the two hazards as dependent competing risks which are estimated jointly.
Abstract: As applied to the behavior of homeowners with mortgages, option theory predicts that mortgage prepayment or default will be exercised if the call or put option in in the money by some specific amount. Our analysis: tests the extent to which the option approach can explain default and prepayment behavior; evaluates the practical importance of modeling both options simultaneously; and models the unobserved herterogeneity of borrowers in the home mortgage market. The paper presents a unified model of the competing risks of mortgage termination by prepayment and default, considering the two hazards as dependent competing risks which are estimated jointly. It also accounts for the unobserved heterogeneity among borrowers, and estimates the unobserved heterogeneity simultaneously with the parameters and baseline hazards associated with prepayment and default functions. Our results show that the option model, in its most straightforward version, does a good job of explaining default and prepayment; but it is not enough by itself. The simultaneity of the options is very important empirically in explaining behavior. The results also show that there exists significant heterogeneity among mortgage borrowers. Ignoring this heterogeneity results in serious errors in estimating the prepayment behavior of homeowners.

585 citations

Journal Article•DOI•
Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options

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John M. Quigley1, Yongheng Deng2, Robert Van Order3•
University of California, Berkeley1, University of Wisconsin-Madison2, Freddie Mac3
01 Feb 1999-Social Science Research Network
TL;DR: In this article, the authors present a unified model of the competing risks of mortgage termination by prepayment and default, considering the two hazards as dependent competing risks which are estimated jointly.
Abstract: As applied to the behavior of homeowners with mortgages, option theory predicts that mortgage prepayment or default will be exercised if the call or put option is in the money by some specific amount Our analysis: tests the extent to which the option approach can explain default and prepayment behavior; evaluates the practical importance of modeling both options simultaneously; and models the unobserved heterogeneity of borrowers in the home mortgage market The paper presents a unified model of the competing risks of mortgage termination by prepayment and default, considering the two hazards as dependent competing risks which are estimated jointly It also accounts for the unobserved heterogeneity among borrowers, and estimates the unobserved heterogeneity simultaneously with the parameters and baseline hazards associated with prepayment and default functions Our results show that the option model, in its most straightforward version, does a good job of explaining default and prepayment; but it is not enough by itself The simultaneity of the options is very important empirically in explaining behavior The results also show that there exists significant heterogeneity among mortgage borrowers Ignoring this heterogeneity results in serious errors in estimating the prepayment behavior of homeowners

432 citations

Journal Article•DOI•
Rational Prepayment and the Valuation of Mortgage-Backed Securities

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Richard Stanton1•
University of California, Berkeley1
01 Jul 1995-Review of Financial Studies
TL;DR: In this article, the authors present a new model of mortgage prepayments, based on rational decisions by mortgage holders, which is estimated using a version of Hansen's (1982) generalized method of moments.
Abstract: This article presents a new model of mortgage prepayments, based on rational decisions by mortgage holders. These mortgage bolders face beterogeneous transaction costs, which are explicitly modeled. The model is estimated using a version of Hansen’s (1982) generalized method of moments, and is sbown to capture many of the empirical features of mortgage prepayment. Estimation results indicate that mortgage holders act as tbougb tbey face transaction costs tbat far exceed tbe explicit Costs usually incurred on refinancing. They also wait an average of more than a year before refinancing, even when it is optimal to do so. The model fits observed prepayment behavior as well as thee recent empirical model of Schwartz and Torous (1989). Implications for pricing mortgage-backed securities are’ discussed

399 citations

"Negative Equity and Foreclosure: Th..." refers background in this paper

  • ...…there is substantial heterogeneity in default behavior across borrowers.23 A common explanation of this finding, advocated in the literature (see Stanton, 1995, for example), is that significant transactions costs are associated with defaulting, and these transactions costs differ across…...

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  • ...To be attractive to the lender, loss mitigation must increase expected loan recovery (so equation (9) must exceed (8))....

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  • ...The expected recovery without it is, E[Recovery] = α0(pH − λ) + (1 − α0)m, (8)...

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  • ...If equation (9) exceeds equation (8), then policy (α1, m , f) makes sense from a lender’s profit-maximizing perspective....

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Journal Article•DOI•
Valuing Commercial Mortgages: An Empirical Investigation of the Contingent-Claims Approach to Pricing Risky Debt

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Sheridan Titman, Walter N. Torous
01 Jun 1989-Journal of Finance
TL;DR: In this paper, the authors empirically investigated a contingent-claims model of commercial mortgage pricing and found that the magnitude of the observed default premia for a sample of non-prepayable fixed rate bullet mortgages can be explained by the contingent claims model.
Abstract: This paper empirically investigates a contingent-claims model of commercial mortgage pricing. We find that the magnitude of the observed default premia for a sample of nonprepayable fixed rate bullet mortgages can be explained by the contingent-claims model. In addition, the model explains a significant proportion of the period-to-period changes in the default premia. However, given an assumed negative correlation between building value changes and interest rate changes, the model's risk structure tends to increase less steeply with increasing maturity than the observed risk structure. SINCE THE SEMINAL WORK of Black and Scholes (1973), corporate liabilities have been modeled as options on the total value of the firm. This contingent-claims approach to bond pricing was refined by Merton (1974) to allow for cash dispersals prior to the bonds' maturities and by Brennan and Schwartz (1980) and Ingersoll (1987) to allow for interest rate uncertainty. Although variants of these bond pricing models are currently being used extensively on Wall Street, they have not been tested extensively. Moreover, empirical studies have not successfully accounted for the observed spread between the rates on risky and default-free debt. Jones, Mason, and Rosenfeld (1984) empirically investigate a model that assumes a nonstochastic term structure of interest rates, while Ramaswamy and Sundaresan (1986) examine a model with stochastic interest rates to price floating rate notes. In both cases, the models could not explain the observed default premia. The relative lack of empirical analysis is due partly to the complicated nature of corporate bonds. Major corporations generally have a large number of different bond issues outstanding that have different priorities in the event that the firm goes bankrupt. Moreover, the bonds can have a variety of covenants specifying sinking fund provisions, conditions under which technical default will occur, and other restrictions that can have an impact on their value. Although these complications do not preclude pricing various bond issues on a case-by-case basis, they make it difficult to test systematically the accuracy of the pricing model.

295 citations

Journal Article•DOI•
The Evolution of the Subprime Mortgage Market

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Souphala Chomsisengphet, Anthony Pennington-Cross
01 Jan 2006-Federal Reserve Bank of St Louis Review
TL;DR: Subprime lending has introduced a substantial amount of risk-based pricing into the mortgage market by creating a myriad of prices and product choices largely determined by borrower credit history (mortgage and rental payments, foreclosures and bankruptcies, and overall credit scores) and down payment requirements as mentioned in this paper.
Abstract: This paper describes subprime lending in the mortgage market and how it has evolved through time. Subprime lending has introduced a substantial amount of risk-based pricing into the mortgage market by creating a myriad of prices and product choices largely determined by borrower credit history (mortgage and rental payments, foreclosures and bankruptcies, and overall credit scores) and down payment requirements. Although subprime lending still differs from prime lending in many ways, much of the growth (at least in the securitized portion of the market) has come in the least-risky (A‐) segment of the market. In addition, lenders have imposed prepayment penalties to extend the duration of loans and required larger down payments to lower their credit risk exposure from high-risk loans.

278 citations

"Negative Equity and Foreclosure: Th..." refers background in this paper

  • ...These include a measure of the borrower’s equity in the home, which is a linear combination of the initial LTV ratio and cumulative house price appreciation since the time of purchase [equation (1)], unemployment rates at the town level from the Bureau of Labor Statistics (BLS), the contemporaneous six-month LIBOR,(14) median household income and the percentage of minority households from the 2000 Census at the zip code level, an indicator variable that helps identify whether the borrower financed the purchase with a mortgage from a subprime lender,(15) and indicator variables for multi-family homes and condominiums....

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  • ...11For a more detailed discussion of the emergence of the subprime mortgage market see Pennington-Cross (2002) and Chomsisengphet and Pennington-Cross (2006)....

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Related Papers (5)
Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options

[...]

01 Feb 1999-Social Science Research Network
John M. Quigley, Yongheng Deng, Robert Van Order
The Rise in Mortgage Defaults

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01 Nov 2008-Journal of Economic Perspectives
Christopher J. Mayer, Karen M. Pence, Shane M. Sherlund
How Ruthless Is Mortgage Default? A Review and Synthesis of the Evidence

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01 Jan 2001
Kerry D. Vandell
Recourse and residential mortgage default: Evidence from US states

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01 Sep 2011-Review of Financial Studies
Andra C. Ghent, Marianna Kudlyak
The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis

[...]

01 Apr 2008-Social Science Research Network
Atif Mian, Amir Sufi, Amir Sufi
Frequently Asked Questions (15)
Q1. What are the contributions in this paper?

Their finding is consistent with historical evidence: the authors examine more than 100,000 homeowners in Massachusetts who had negative equity during the early 1990s and find that fewer than 10 percent of these owners eventually lost their home to foreclosure. This paper, which may be revised, is available on the web site of the Federal Reserve Bank of Boston at http: //www. bos. frb. org/economic/ppdp/2008/ppdp0803. htm. The views expressed in this paper are solely those of the authors and not necessarily those of the Federal Reserve Bank of Boston or the Federal Reserve System. 

In future work, the authors hope to build a model that incorporates a richer, dynamic environment more consistent with the choices and decisions borrowers actually face. 

Depending on house price appreciation going forward, the authors estimate that such a policy would prevent 15 to 40 percent of foreclosures on negative equity borrowers. 

For a household with no savings and positive credit card debt, the cost of funds would be their credit card interest rate, since they would need to use their credit card to borrow. 

for a household with substantial savings, the cost of funds would be the savings rate, which is the rate at which the household would borrow from itself. 

This is because factors such as individual household-level income shocks (especially unemployment), health shocks, and other family-level shocks (death or divorce) have been shown to be important determinants of foreclosure incidence. 

even if lenders thought they would lose 50 percent of the value of the mortgage in foreclosure, to avoid losing money, their loss mitigation scheme could reduce the value of the mortgage only by five percent. 

These include a measure of the borrower’s equity in the home, which is a linear combination of the initial LTV ratio and cumulative house price appreciation since the time of purchase [equation (1)], unemployment rates at the town level from the Bureau of Labor Statistics (BLS), the contemporaneous six-month LIBOR,14 median household income and the percentage of minority households from the 2000 Census at the zip code level, an indicator variable that helps identify whether the borrower financed the purchase with a mortgage from a subprime lender,15 and indicator variables for multi-family homes and condominiums. 

The relevant cost of funds for the former is the credit card interest rate, say, 20 percent, and for the latter is the return on riskless savings, 5 percent. 

Using an econometric model of foreclosures estimated using the Massachusetts data, the authors predict that between 6,500 and 7,600 of these borrowers will lose their homes to foreclosure by the end of 2010. 

For the first scenario, the duration model predicts that about 6.9 percent (6,500 households) of the borrowers with negative equity in 2007:Q4 will experience a foreclosure over the next three years. 

(11)This implies that the maximum level of assistance for which a policy makes financial sense to the lender is 1/24th, or just over 2 percent, of the anticipated loss given foreclosure. 

To forecast the percentage of negative equity borrowers who will experience a future foreclosure, the authors use the duration model employed in GSW. 

a decrease in housing equity is estimated to have a positive effect on the probability of default, while a decrease in housing values that results in a position of negative equity is estimated to have an even larger positive effect on foreclosure incidence, although this effect is not statistically significantly different from zero. 

25 However, this fix only reduces the maximum level of assistance from 1/24th of the anticipated loss given foreclosure to 1/10th of the loss.