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Strategic loan modification: An options-based response to strategic default

  • Das, Sanjiv R.
  • Meadows, Ray

This paper presents a parsimonious barrier model for the optimal principal reset in a loan modification, thereby maximizing the loan value to the lender bank and minimizing the likelihood of strategic foreclosure by the homeowner. Writing down the loan-to-value (LTV) ratio will reduce the present value of future payments on the loan, but will also reduce the probability of default, thereby saving foreclosure losses. The optimal trade-off of these two countervailing effects will pinpoint the optimal LTV at which the loan must be reset. We present a simple barrier option decomposition of the loan value that makes the optimization of LTV easy to implement. An extension of the model is shown to account for varying growth rate assumptions about house prices. The model in this paper specifically accounts for the homeowner’s willingness to pay, and uses the framework to model shared-appreciation mortgages (SAMs).

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

Volume (Year): 37 (2013)
Issue (Month): 2 ()
Pages: 636-647

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Handle: RePEc:eee:jbfina:v:37:y:2013:i:2:p:636-647
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  1. Christopher Foote & Kristopher Gerardi & Lorenz Goette & Paul S. Willen, 2009. "Reducing foreclosures: no easy answers," FRB Atlanta Working Paper No. 2009-15, Federal Reserve Bank of Atlanta.
  2. Kau, James B. & Keenan, Donald C., 1999. "Patterns of rational default," Regional Science and Urban Economics, Elsevier, vol. 29(6), pages 765-785, November.
  3. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
  4. John Y. Campbell & Stefano Giglio & Parag Pathak, 2009. "Forced Sales and House Prices," NBER Working Papers 14866, National Bureau of Economic Research, Inc.
  5. 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.
  6. 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.
  7. Manuel Adelino & Kristopher Gerardi & Paul S. Willen, 2009. "Why Don't Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures and Securitization," NBER Working Papers 15159, National Bureau of Economic Research, Inc.
  8. Christopher L. Foote & Kristopher Gerardi & Paul S. Willen, 2008. "Negative equity and foreclosure: theory and evidence," Public Policy Discussion Paper 08-3, Federal Reserve Bank of Boston.
  9. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  10. Ambrose, Brent W & Capone, Charles A, Jr & Deng, Yongheng, 2001. "Optimal Put Exercise: An Empirical Examination of Conditions for Mortgage Foreclosure," The Journal of Real Estate Finance and Economics, Springer, vol. 23(2), pages 213-34, September.
  11. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
  12. Boudoukh, Jacob, et al, 1997. "Pricing Mortgage-Backed Securities in a Multifactor Interest Rate Environment: A Multivariate Density Estimation Approach," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 405-46.
  13. Christopher L. Foote & Kristopher S. Gerardi & Lorenz Goette & Paul S. Willen, 2009. "Reducing foreclosures," Public Policy Discussion Paper 09-2, Federal Reserve Bank of Boston.
  14. Chris Foote & Jeff Fuhrer & Eileen Mauskopf & Paul Willen, 2009. "A proposal to help distressed homeowners: a government payment-sharing plan," Public Policy Brief, Federal Reserve Bank of Boston.
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