An Empirical Model of Subprime Mortgage Default

September 16, 2010

by Scott Sambucci

3 comments

Check out this paper by Minjung Park at the University of Minnesota – “An Empirical Model of Subprime Mortgage Default from 2000 to 2007.”   Park empirically identifies four drivers to subprime mortgage defaults, two of which directly involve housing prices and market conditions.

I know – sounds simple right?  Market gets bad, borrower defaults.  Unfortunately, there are still too many mortgage servicers and lenders (read: almost all of them…) basing default projections on a BPO instead including market conditions in their analysis.   The BPOs are a great starting point to determining LTVs, but they are inherently flawed for future borrower behavior because they are based on lagging transaction data and don’t account for real-time and future market conditions.

Don’t take our word for it, even though we’ve been pontificating about this for a while, [sigh].  From the paper (my emphasis added):

In this paper, we ask what can explain the recent increase in defaults among subprime mortgages. Since these defaults were the initial catalyst for the financial turmoil, it is crucial to identify the key drivers behind them. We use a uni…ed framework to assess the relative importance of four potential causes. The …rest is falling home prices. When the outstanding mortgage balance exceeds the current market value of a house, there is an incentive to default. Default in such cases is referred to by the literature as exercising the “put-option”value of the mortgage in the literature…

Second, when agents have dynamic incentives, lowered expectations about future home prices also increase the propensity to default. When home prices are expected to appreciate less or depreciate, borrowers have more incentive to default because of the reduction in anticipated capital gains from owning the house.

(FYI – Rising interest rates and short-term credit constraints are the third and fourth reasons cited.)

Park also writes:

Our results suggest that declining house prices and deterioration in borrower and loan characteristics affecting borrowers’ ’ability to pay are the two most important factors behind the recent increase in subprime defaults. The effect of declining home prices on default is substantial. [emphasis added]

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