Pulling the Trigger: Default Option Exercise Over the Business Cycle

45 Pages Posted: 20 Sep 2014

See all articles by Xudong An

Xudong An

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Yongheng Deng

Wisconsin School of Business, University of Wisconsin-Madison

Stuart A. Gabriel

University of California, Los Angeles - Anderson School of Management

Date Written: September 17, 2014

Abstract

We provide new evidence of cyclical variation in mortgage default option exercise. For a given level of negative equity, borrower propensity to default rose markedly during the financial crisis and in hard-hit metropolitan areas. Analysis of time-series and panel data indicates the importance of economic risk, consumer sentiment, and federal policy innovations in explanation of borrower default behavior. Further, simulation shows that changes in behavior during the crisis period were more salient to the rise in defaults than were increases in negative equity. Findings provide new insights to shifts in borrower behavior relevant to originators, investors, insurers, and regulators of the $10 trillion U.S. mortgage market. From a risk modeling perspective, findings underscore the importance of model instability and provide guidance on mortgage underwriting, pricing, and contract design. Results also shed light on adverse unintended consequences of federal programs designed to mitigate mortgage failures.

Suggested Citation

An, Xudong and Deng, Yongheng and Gabriel, Stuart A., Pulling the Trigger: Default Option Exercise Over the Business Cycle (September 17, 2014). Available at SSRN: https://ssrn.com/abstract=2498179 or http://dx.doi.org/10.2139/ssrn.2498179

Xudong An

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Yongheng Deng

Wisconsin School of Business, University of Wisconsin-Madison ( email )

4110 Grainger Hall
975 University Avenue
Madison, WI 53706
United States
+1 (608) 262-4865 (Phone)

HOME PAGE: http://https://bus.wisc.edu/faculty/yongheng-deng

Stuart A. Gabriel (Contact Author)

University of California, Los Angeles - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States
310-825-2922 (Phone)
310-206-5455 (Fax)

HOME PAGE: http://www.anderson.ucla.edu

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