Default when Current House Prices are Uncertain

Abstract

We specify a new model of homeowner mortgage default. In our model, homeowners do not know the current price of their home until they sell; rather, they maintain an unbiased guess of the price and optimally update this guess as new information, such as the sale price of similar homes, is observed. Compared to the predictions of a model where homeowners know the current price with certainty, uncertainty about the price considerably reduces the probability homeowners default even when the current price is likely substantially less than the mortgage balance. We estimate model parameters using data on self-assessed house prices, house-price indexes and mortgage defaults. We find uncertainty about the current level of house prices reduced defaults for a cohort of prime mortgages issued in 2006 by 25 percent in 2010 and 2011.

Keywords: uncertainty, default, housing, house value, under water

JEL Classification: G1, D1, R21