How Ruthless Is Mortgage Default? A Review and Synthesis of the Evidence

How Ruthless Is Mortgage Default? A Review and Synthesis of the Evidence

Pure option-theoretic mortgage pricing models assume that the borrower will default immediately when the value of the property drops to the level of the mortgage value (“ruthless” default) rather than waiting until it drops further (“nonruthless” default or default underexercise). This article reviews and synthesizes the relevant literature to question whether this assumption is confirmed empirically. The pure option-theoretic model does correctly handle one form of “nonruthless” default—borrowers would optimally not default immediately upon reaching negative book equity because they would sacrifice the right to default in the future, which could be more valuable. However, the model disregards several realities that could drive nonruthlessness from another perspective: (1) transaction costs associated with default, (2) solvency, and (3) the lender’s role in affecting default through the decision to foreclose. The article concludes with a recommended model synthesis and research agenda to validate a revised model that incorporates these considerations.

Kerry D. Vandell

Journal of Housing Research

1995

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By |2018-01-01T00:00:00-08:00January 1st, 2018|Financial Regulation, Mortgage Finance, Reference|