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Is There a Puzzle in Underwater Mortgage Default?

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A recurring question in the mortgage default literature is why underwater default is rare relative to model predictions. We find that one answer is miscalibration of flow payoffs. We build a novel, detailed quantitative model of mortgage default and find that realistic rent dynamics plus mild levels of default costs are sufficient to eliminate negative-equity strategic default. We present further empirical results supporting our model's focus on flow payoffs. Our model addresses the underwater mortgage default puzzle, offers more realistic interpretations of policy consequences, and reinforces the theoretical effectiveness of cash-flow-based interventions.

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  • Lara Loewenstein & Paul S. Willen & Yuxi Yao & David Hao Zhang, 2025. "Is There a Puzzle in Underwater Mortgage Default?," Working Papers 25-22, Federal Reserve Bank of Cleveland.
    • Handle: RePEc:fip:fedcwq:101796
    DOI: 10.26509/frbc-wp-202522
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    JEL classification:

    • D15 - Microeconomics - - Household Behavior - - - Intertemporal Household Choice; Life Cycle Models and Saving
    • G51 - Financial Economics - - Household Finance - - - Household Savings, Borrowing, Debt, and Wealth
    • R30 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location - - - General

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