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What motivates a subprime borrower to default?

  • Daglish, Toby

This paper uses a real options approach to analyse the exercise of the default option embedded in mortgages. In particular, it examines a subprime household who borrows at a premium, but hopes to refinance at prime rates if their house appreciates. We show how these optimal default decisions can be used to calculate probabilities of default - an important input for risk management and pricing purposes. Numerical examples are provided, calibrated to US data. In a low interest rate environment, the credit-upgrade potential may discourage subprime borrowers from defaulting. However, default probabilities are highly sensitive to changes in interest rates and house prices. This provides a rational explanation for the prevalence of adjustable rate mortgages among subprime borrowers, and the subsequent large numbers of defaults, when interest rates rose and house prices declined.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 33 (2009)
Issue (Month): 4 (April)
Pages: 681-693

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Handle: RePEc:eee:jbfina:v:33:y:2009:i:4:p:681-693
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  1. Deng, Yongheng & Quigley, John M. & Van Order, Robert, 1999. "Mortgage Terminations, Heterogeneity, and the Exercise of Mortgage Options," Berkeley Program on Housing and Urban Policy, Working Paper Series qt96r560pg, Berkeley Program on Housing and Urban Policy.
  2. Stanton, Richard, 1995. "Rational Prepayment and the Valuation Mortgage-Backed Securities," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 677-708.
  3. Paul Bennett & Richard Peach & Stavros Peristiani, 2000. "Implied Mortgage Refinancing Thresholds," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 28(3), pages 405-434.
  4. Calhoun, Charles A & Deng, Yongheng, 2002. "A Dynamic Analysis of Fixed- and Adjustable-Rate Mortgage Terminations," The Journal of Real Estate Finance and Economics, Springer, vol. 24(1-2), pages 9-33, Jan.-Marc.
  5. Kau, James B, et al, 1993. "Option Theory and Floating-Rate Securities with a Comparison of Adjustable- and Fixed-Rate Mortgages," The Journal of Business, University of Chicago Press, vol. 66(4), pages 595-618, October.
  6. Caplin, Andrew & Freeman, Charles & Tracy, Joseph, 1997. "Collateral Damage: Refinancing Constraints and Regional Recessions," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(4), pages 496-516, November.
  7. Kau, James B. & Keenan, Donald C. & Muller, Walter III & Epperson, James F., 1987. "The valuation and securitization of commercial and multifamily mortgages," Journal of Banking & Finance, Elsevier, vol. 11(3), pages 525-546, September.
  8. Souphala Chomsisengphet & Anthony Pennington-Cross, 2006. "Subprime refinancing: equity extraction and mortgage termination," Working Papers 2006-023, Federal Reserve Bank of St. Louis.
  9. Kau, James B, et al, 1992. "A Generalized Valuation Model for Fixed-Rate Residential Mortgages," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 24(3), pages 279-99, August.
  10. Kau James B. & Keenan Donald C. & Kim Taewon, 1994. "Default Probabilities for Mortgages," Journal of Urban Economics, Elsevier, vol. 35(3), pages 278-296, May.
  11. Stavros Peristiani & Paul Bennett & Gordon Monsen & Richard Peach & Jonathan Raiff, 1997. "Credit, equity, and mortgage refinancings," Economic Policy Review, Federal Reserve Bank of New York, issue Jul, pages 83-99.
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