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Efficient Mortgage Default Option Exercise: Evidence from Loss Severity

This paper extends options-based mortgage default theory to include transaction costs. When transaction costs are considered, the rational borrower will default only when the value of the collateral falls below the mortage value by an amount equal to the net transaction costs. Since, for most borrowers, net transaction costs are positive, standard measures of equity may be significantly negative by the time the rational borrower exercises the default option. This research shows theoretically and empirically the effects of frictions on the individual strike price. The addition of transaction costs to the theory provides several testable implications for equity loss severity. First, the longer the foreclosure process and the period of free rent to the borrower, the lower the severity. Second, severity will be smaller when bankruptcy has been declared. Third, severity is decreasing in the contract decreasing function of the probability of a deficiency judgment. The empirical results, using servicing and foreclosure data from a large northeastern thrift, support the theoretical model.

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Article provided by American Real Estate Society in its journal Journal of Real Estate Research.

Volume (Year): 10 (1995)
Issue (Month): 5 ()
Pages: 543-556

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Handle: RePEc:jre:issued:v:10:n:5:1995:p:543-556
Contact details of provider: Postal: American Real Estate Society Clemson University School of Business & Behavioral Science Department of Finance 401 Sirrine Hall Clemson, SC 29634-1323
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Order Information: Postal: Diane Quarles American Real Estate Society Manager of Member Services Clemson University Box 341323 Clemson, SC 29634-1323
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  1. Chester Foster & Robert Order, 1985. "FHA Terminations: A Prelude to Rational Mortgage Pricing," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 13(3), pages 273-291.
  2. Kerry D. Vandell, 1994. "How Ruthless is Mortgage Default? Prepared under contract with Fannie Mae," Wisconsin-Madison CULER working papers 94-04, University of Wisconsin Center for Urban Land Economic Research.
  3. Vassilis Lekkas & John M. Quigley & Robert Order, 1993. "Loan Loss Severity and Optimal Mortgage Default," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 21(4), pages 353-371.
  4. James B. Kau & Taewon Kim, 1994. "Waiting to Default: The Value of Delay," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 22(3), pages 539-551.
  5. Quigley, John M., 2006. "Urban Economics," Berkeley Program on Housing and Urban Policy, Working Paper Series qt0jr0p2tk, Berkeley Program on Housing and Urban Policy.
  6. Clauretie, Terrence M & Herzog, Thomas N, 1990. "The Effect of State Foreclosure Laws on Loan Losses: Evidence from the Mortgage Insurance Industry," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 22(2), pages 221-33, May.
  7. James F. Epperson & James B. Kau & Donald C. Keenan & Walter J. Muller, 1985. "Pricing Default Risk in Mortgages," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 13(3), pages 261-272.
  8. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  9. 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.
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