Hostname: page-component-7b7567c8c-7pwfn Total loading time: 0 Render date: 2026-11-14T22:07:19.843Z Has data issue: false hasContentIssue false
  • English
  • Français

The Principal Principle

Published online by Cambridge University Press:  04 October 2012

Sanjiv R. Das
Sanjiv R. Das*
Affiliation:
srdas@scu.edu, Leavey School of Business, Santa Clara University, 500 El Camino Real, Santa Clara, CA 95053.
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the 'Save PDF' action button.

I analyze optimal loan modification schemes in a stochastic home price and stochastic interest-rate environment. Lenders maximize loan values by managing the borrower’s option to default on the loan and prepayment option. Given negative equity, controlling for the borrower’s ability to pay, rate reductions and maturity extensions result in a higher probability of redefault by homeowners even after modification of their loans. In contrast, loan write-downs (the Principal Principle), not a favored recipe, are value maximizing for the lender. A shared-appreciation mortgage enhances the ability to pay, mitigates adverse selection, and reduces the present value of expected deadweight foreclosure costs.

Information

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 47 , Issue 6 , December 2012, pp. 1215 - 1246
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2012

References

Adelino, M.; Gerardi, K.; and Willen, P. S.. “Why Don’t Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures and Securitization.” FRB Boston Public Policy Discussion Paper Series, No. 09–4 (2009).CrossRefGoogle Scholar
Ambrose, B. W., and Capone, C. A. Jr. “Cost-Benefit Analysis of Single-Family Foreclosure Alternatives.” Journal of Real Estate Finance and Economics, 13 (1996), 105–120.CrossRefGoogle Scholar
Ambrose, B. W.; Capone, C. A. Jr.; and Deng, Y. “Optimal Put Exercise: An Empirical Examination of Conditions for Mortgage Foreclosure.” Journal of Real Estate Finance and Economics, 23 (2001), 213–234.CrossRefGoogle Scholar
Anderson, R. W., and Sundaresan, S.. “The Design and Valuation of Debt Contracts.” Review of Financial Studies, 9 (1996), 37–68.CrossRefGoogle Scholar
Campbell, J., and Cocco, J.. “A Model of Mortgage Default.” Working Paper, Harvard University (2010).CrossRefGoogle Scholar
Case, K., and Shiller, R.. “Prices of Single-Family Homes Since 1970: New Indices for Four Cities.” New England Economic Review (1987), 45–56.Google Scholar
Cohen-Cole, E., and Morse, J.. “Your House or Your Credit Card, Which Would You Choose? Personal Delinquency Tradeoffs and Precautionary Liquidity Motives.” Working Paper, University of Maryland (2009).CrossRefGoogle Scholar
Cox, J.; Ingersoll, J.; and Ross, S.. “A Theory of the Term Structure of Interest Rates.” Econometrica, 53 (1985), 385–407.CrossRefGoogle Scholar
Cox, J. C.; Ross, S. A.; and Rubinstein, M.. “Option Pricing: A Simplified Approach.” Journal of Financial Economics, 7 (1979), 229–263.CrossRefGoogle Scholar
Deng, Y.; Quigley, J. M.; and van Order, R.. “Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options.” Econometrica, 68 (2000), 275–307.CrossRefGoogle Scholar
Edmans, A.“The Responsible Homeowner Reward: An Incentive-Based Solution to Strategic Mortgage Default.” Working Paper, University of Pennsylvania (2010).CrossRefGoogle Scholar
Elul, R.“Securitization and Mortgage Default: Reputation vs. Adverse Selection.” Working Paper, Federal Reserve Bank of Philadelphia (2009).Google Scholar
Federal Deposit Insurance Corporation. “FDIC Loan Modification Plan.” Washington, DC (2009).Google Scholar
Foote, C.; Gerardi, K.; Goette, L.; and Willen, P.. “Reducing Foreclosures: No Easy Answers.” NBER Macroeconomics Annual, 24 (2009), 89–138.CrossRefGoogle Scholar
Ghent, A. C. “Securitization and Mortgage Renegotiation: Evidence from the Great Depression.” Review of Financial Studies, 24 (2011), 1814–1847.CrossRefGoogle Scholar
Goodman, L. S. “Dimensioning the Housing Crisis.” Financial Analysts Journal, 66 (2010), 26–37.CrossRefGoogle Scholar
Guerrieiri, V.; Hartley, D.; and Hurst, E.. “Endogenous Gentrification and Housing Price Dynamics.” Working Paper, NBER (2010).CrossRefGoogle Scholar
Guiso, L.; Sapienza, P.; and Zingales, L.. “The Determinants of Attitudes towards Strategic Default on Mortgages.” Journal of Finance, forthcoming (2012).Google Scholar
Harding, J. P.; Miceli, T. J.; and Sirmans, C. F.. “Deficiency Judgments and Borrower Maintenance: Theory and Evidence.” Journal of Housing Economics, 9 (2000), 267–285.CrossRefGoogle Scholar
Harding, J. P.; Rosenblatt, E.; and Yao, V. W.. “The Contagion Effect of Foreclosed Properties.” Journal of Urban Economics, 66 (2009), 164–178.CrossRefGoogle Scholar
Harding, J. P., and Sirmans, C. F.. “Renegotiation of Troubled Debt: The Choice between Discounted Payoff and Maturity Extension.” Real Estate Economics, 30 (2002), 475–503.CrossRefGoogle Scholar
Heath, D.; Jarrow, R.; and Morton, A.. “Bond Pricing and the Term Structure of Interest Rates: A Discrete Time Approximation.” Journal of Financial and Quantitative Analysis, 25 (1990),419–440.CrossRefGoogle Scholar
Heath, D.; Jarrow, R.; and Morton, A.. “Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation.” Econometrica, 60 (1992), 77–106.CrossRefGoogle Scholar
Kau, J. B., and Keenan, D. C.. “Patterns of Rational Default.” Regional Science and Urban Economics, 29 (1999), 765–785.CrossRefGoogle Scholar
Kau, J. B.; Keenan, D. C.; Muller, W. J. III; and Epperson, J. F.. “A Generalized Valuation Model for Fixed-Rate Residential Mortgages.” Journal of Money, Credit and Banking, 24 (1992), 279–299.CrossRefGoogle Scholar
Kelly, A.“Appraisals, Automated Valuation Models, and Mortgage Default.” Working Paper, Center for Economics, U.S. Government Accountability Office, Washington, DC (2006).CrossRefGoogle Scholar
Khandani, A.; Lo, A.; and Merton, R.. “Systemic Risk and the Refinancing Ratchet Effect.” Working Paper 15362, NBER (2009).CrossRefGoogle Scholar
Levitin, A. J. “Resolving the Foreclosure Crisis: Modification of Mortgages in Bankruptcy.” Wisconsin Law Review (2009), 565–655.Google Scholar
Liebowitz, S.“New Evidence on the Foreclosure Crisis.” The Wall Street Journal, http://online.wsj.com/article/SB124657539489189043.html (July 3, 2009).Google Scholar
Meadows, R.“A Quantitative Comparison of Alternative Loan Modification Strategies.” White Paper, Recovery Partners, Inc. (2009).Google Scholar
Mian, A., and Sufi, A.. “House Prices, Home Equity-Based Borrowing, and the U.S. Household Leverage Crisis.” American Economic Review, 101 (2011), 2132–2156.CrossRefGoogle Scholar
O’Brien, J.“Stabilizing the Housing Market.” Working Paper, University of California at Berkeley (2008).Google Scholar
Piskorski, T.; Seru, A.; and Vig, V.. “Securitization and Distressed Loan Renegotiation: Evidence from the Subprime Mortgage Crisis.” Journal of Financial Economics, 97 (2010), 369–397.CrossRefGoogle Scholar
Simon, R.“Playing Mortgage Market Proves Tricky.” The Wall Street Journal, http://online.wsj.com/article/SB124459303760100287.html (June 10, 2009).Google Scholar
Sundaram, R., and Das, S.. Derivatives: Principles and Practice. New York: McGraw-Hill (2010).Google Scholar
U.S. Department of the Treasury. “OCC and OTS Mortgage Metrics Report: Disclosure of National Bank and Federal Thrift Mortgage Loan Data (first quarter).” Washington, DC (June 2009).Google Scholar
White, A. M. “Deleveraging the American Homeowner: The Failure of 2008 Voluntary Mortgage Contract Modifications.” Connecticut Law Review, 41 (2009a), 1107–1132.Google Scholar
White, A. M. “Rewriting Contracts, Wholesale: Data on Voluntary Mortgage Modifications from 2007 and 2008 Remittance Reports.” Fordham Urban Law Journal, 36 (2009b), 509.Google Scholar