Mortgage-Default Research and the Recent Foreclosure Crisis
This paper reviews how previous and contemporary mortgage-default research informed—or, in some cases, should have informed–policy discussions during the foreclosure crisis. It also evaluates default behavior during the crisis in light of previous findings, and it discusses the new research questions and opportunities that the crisis has created.
The authors note that all theories of default imply that negative equity is a necessary condition for default, because borrowers with positive equity can avoid default by selling their homes and pocketing what’s left over after paying off their mortgages. But different theories of default are less concrete about what a homeowner should do once equity becomes negative. Arbitrage-based models grounded in formal theories of household optimization imply that default depends only on aggregate factors such as house prices and interest rates, not on the individual characteristics or circumstances of the borrower. Conversely, so-called double-trigger models allow adverse life events such as job loss and illness to precipitate defaults. Double-trigger models generate more-realistic empirical predictions, but they are less grounded in formal household optimization. This paper discusses how the foreclosure crisis has encouraged economists to blend these two extremes into a third alternative that provides an optimizing foundation for the default function and formalizes the previously ad hoc approach of double-trigger models.