Mortgage Contracts and Underwater Default

Yerkin Kitapbayev, Scott Robertson

    Research output: Contribution to journalArticlepeer-review

    Abstract

    We analyze recently proposed mortgage contracts that aim to eliminate selective borrower default when the loan balance exceeds the house price (the "underwater"effect). We show contracts that automatically reduce the outstanding balance in the event of house price decline do eliminate selective default, but they may induce prepayment in low price states. However, low state prepayments vanish if the benefit from home ownership is sufficiently high. We also show that capital gain sharing features, such as prepayment penalties in high house price states, are ineffective as they virtually eliminate prepayment. For observed foreclosure costs, we find that contracts with automatic balance adjustments become preferable to the traditional fixed-rate contracts at mortgage rate spreads between 20-50 basis points. We obtain these results for perpetual versions of the contracts using an American options pricing methodology, in a continuous-time model with diffusive home prices. The contracts' values and decision rules are associated with free boundary problems, which admit semiexplicit solutions.

    Original languageBritish English
    Pages (from-to)315-359
    Number of pages45
    JournalSIAM Journal on Financial Mathematics
    Volume15
    Issue number2
    DOIs
    StatePublished - 2024

    Keywords

    • mortgage contracts
    • optimal stopping
    • underwater default

    Fingerprint

    Dive into the research topics of 'Mortgage Contracts and Underwater Default'. Together they form a unique fingerprint.

    Cite this