Efficient Mortgage Default Option Exercise: Evidence from Loss Severity

Abstract

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 mortgage 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 effect 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 rate. Fourth, severity is increasing in the market interest rate. Finally, severity is a 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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