, Volume 46, Issue 2, pp 355-378
Date: 28 Jul 2011

Residential Mortgage Default: The Roles of House Price Volatility, Euphoria and the Borrower’s Put Option

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House price volatility; lender and borrower perception of price trends, loan and property features; and the borrower’s put option are integrated in a model of residential mortgage default. These dimensions of the default problem have, to our knowledge, not previously been considered altogether within the same investigation framework. We rely on a sample of individual mortgage loans for 20 counties in Florida, over the period 2001 through 2008, third quarter, with housing price performance obtained from repeat sales analysis of individual transactions. The results from the analysis strongly confirm the significance of the borrower’s put as an operative factor in default. At the same time, the results provide convincing evidence that the experience in Florida is in part driven by lenders and purchasers exhibiting euphoric behavior such that in markets with higher price appreciation there is a willingness to accept recent prior performance as an indicator of future risk. This connection illustrates a familiar moral hazard in the housing market due to the limited information about future prices.

This paper has benefited from helpful conversations with Brent Ambrose, Allen Goodman, and Edward Prescott. Also, we thank Shane Sherlund, Tomasz Piskorski and participants in the Conference on Household Portfolio-Choice and Financial Decision-Making at the Rodney L. White Center for Financial Research, Wharton. Mark Watson of the Federal Reserve Bank of Kansas City provided invaluable assistance with the data set. Finally, we want to thank discussants at several meetings of the American Real Estate and Urban Economics Association for valuable suggestions. We are indebted to the Federal Reserve Bank of Richmond and LPS Applied Analytics for providing access to the data via a research affiliation between Brent C Smith and the Federal Reserve Bank of Richmond. All views and errors, however, are the responsibility of the authors and do not reflect those of the Federal Reserve Bank of Richmond, the Federal Reserve System or LPS Applied Analytics.