Embedded Options in the Mortgage Contract

Abstract

Loss mitigation is the process by which lenders attempt to minimize losses associated with foreclosure. As competition increases in the mortgage industry, lenders and servicers are under great pressure to adopt loss mitigation tactics rather than simply use foreclosure as the means of dealing with borrowers in default. However, to date, no study has examined the impact of loss mitigation programs on borrower behavior. This study presents a mortgage pricing model that fully specifies all borrower options with respect to default, including the ability to reinstate the mortgage out of default. This model documents the impact of various loss mitigation programs, including forbearance and anti-deficiency judgments, on borrower behavior. We also explicitly consider the impact of the value of credit on borrower default behavior.

JEL Classification: G12, G13, G21, R21