Pulling the Trigger: Default Option Exercise Over the Business Cycle
45 Pages Posted: 20 Sep 2014
Date Written: September 17, 2014
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.
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