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| Efficient Mortgage Default Option
Exercise: Evidence from Loss Severity Author: Gordon W. Crawford and Eric Rosenblatt Start Page: 543 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 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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