Journal of Housing Research Volume 3, Issue 2 341

Residential Mortgage Default:

A Review of the Literature*
Roberto G. Quercia and Michael A. Stegman**
Abstract
For nearly 30 years, the subject of mortgage default has claimed the attention
of scholars, policy analysts, and government officials. During this time, the
principal purposes of these inquires, their theoretical underpinnings, empiri-
cal estimation techniques, and data sources have undergone substantial
change. This article traces our evolving understanding of residential mortgage
default risk from the early studies to the current literature. Default studies
are divided into three groups: first-, second-, and third-generation studies.
The studies vary in three respects. First, each study chooses a perspective from
which mortgage risk is analyzed: lender, borrower, or institutional. A second
aspect is the different measures studies use to determine mortgage risk:
mortgage interest rate premiums, default rates, delinquency rates, or ex-
pected mortgage losses. Finally, studies follow one of two primary research
approaches, that is, they make either a theoretical or an empirical contribu-
tion to the literature. The last section of this article presents an overall
discussion of the state of residential mortgage default literature and suggests
directions for future research.
Introduction
Increasing opportunities for homeownership has been a long-term goal
in the United States. Today we are a nation of homeowners, with an
ownership rate of about 64 percent (Apgar 1989). Both government
agencies and private lenders have played significant roles in helping
families achieve this ideal by making available the necessary mortgage
financing. Unfortunately, not all mortgages are repaid. Failure to repay
mortgage financing (default) varies substantially with the type of loan
and borrower (Simons 1990). A desire to gain an accurate understanding
of the risk of default represented by loan and borrower characteristics is
at the core of the residential mortgage default literature. This article
*The research reported here was carried out with funding from Fannie Mae.
**Roberto G. Quercia is an assistant professor at the School of Urban and Public Affairs,
University of Texas at Arlington. Michael A. Stegman is Cary C. Boshamer Professor and
chairman of the Department of City and Regional Planning and chairman of Ph.D. curriculum
in public policy analysis, University of North Carolina at Chapel Hill.
342 Roberto G. Quercia and Michael A. Stegman
traces our evolving understanding of residential mortgage default risk
from the early studies to the current literature.
For nearly 30 years, the subject of mortgage default has claimed the
attention of scholars, policy analysts, and government officials. Default
is costly to everybody involved. On the one hand, mortgage default is
costly to lenders and to the federal institutions that guarantee and
insure home mortgages.
l
Costs to lenders and institutions are incurred
when the net cash recouped from foreclosure proceedings is less than
the value of the financial asset. Another cost to lenders is associated
with the restrictions imposed by regulatory authorities when a history
of loan losses impairs the soundness of those institutions (Giliberto and
Houston 1989, p. 56).
On the other hand, default is also costly to borrowers. On an individual
level, a borrower who defaults is penalized with a lower credit rating,
fewer opportunities for future home purchase, and sometimes, even
reduced future employment or advancement opportunities (Giliberto
and Houston 1989). There are also intangible costs to individual borrow-
ers, such as emotional distress experienced when they decide to default.
Default is also costly to borrowers collectively. When default risks are
not properly understood, lenders charge mortgage interest rate premi-
ums to compensate for the above-normal risk represented by borrowers
with certain characteristics.
2
In extreme situations, borrowers may be
denied loans altogether because they are residents of areas considered
risky, regardless of their individual creditworthiness. All of these
situations make credit more expensive and more difficult to obtain for
many families considering a home purchase. A desire to minimize
default costs to both borrowers and lenders is central in default studies.
Studies have focused on several distinct aspects of the default decision,
a fact that reflects the complexity of the mortgage process for both
borrowers and lenders. Typically, borrowers purchase homes with
certain characteristics and in a location to meet their preferences. Home
prices commonly represent several years of annual income, so borrowers
put down some fraction of the price in cash in the form of a down payment
and finance the rest by borrowing against future earnings. Small
differences in loan characteristics become significant in the resulting
1
The Federal Housing Administration provides loan guarantees for residential mortgages.
Federal mortgage insurance can be direct, such as that offered by the Department of Veterans
Affairs, or indirect, such as that funded by insured deposits or agency securities such as those
offered by Fannie Mae, Freddie Mac, and the Government National Mortgage Association.
2
This mortgage interest rate premium is the rate of interest above the normal rate; it is charged
to borrowers considered risky.
Residential Mortgage Default: A Review of the Literature 343
mortgage payment. This significant difference entices borrowers to shop
among lenders for the right combination of down payment, mortgage
interest rate, length of loan, and other factors. Borrowers repay the
mortgage principal, plus the corresponding interest payment, for a
number of years after home purchase. At each payment time, borrowers
have three choices. They can choose to make the scheduled mortgage
payment, not to make the payment, or to pay the balance of the loan
through refinancing or sale of the property.
When scheduled payments are not made, lenders cannot know whether
borrowers are only delaying payment temporarily or stopping mortgage
payments altogether. In practice, when payments are first missed, the
lender considers that the borrower is only delaying payment temporarily
with the intention of renewing payment in the future (delinquency). If
payments are not met for a number of periods (typically three), the
lender considers that the borrower has decided to stop payment com-
pletely (default).
3
The number of nonpayment periods for which borrow-
ers are considered to be delinquent varies from lender to lender and with
the lenders willingness to work with nonpaying borrowers and renego-
tiate the loan terms. This willingness, in turn, is based on the value of
the outstanding debt and the costs of foreclosure.
4
Lenders will choose on the basis of expected losses associated with each
outcome either to renegotiate the loan terms or to foreclose.
5
If lenders
decide that foreclosure is the least cost option, they foreclose and dispose
of the mortgaged property to recover the unpaid mortgage principal,
interests, and costs. In effect, although it is the borrower who stops
payments, it is the lender who decides if default has occurred by choosing
whether to work with the borrower or to foreclose.
When payments are first missed, it is not possible to know whether the
borrower has defaulted or is just delinquent. It is possible retroactively
to identify those delinquent loans that were later cured (mortgage
3
Consistent with Giliberto and Houston (1989), default is considered the transfer of the legal
ownership of the property from the borrower to the lender either through the execution of
foreclosure proceedings or the acceptance of a deed in lieu of foreclosure. This is the definition
used commonly in default studies. This definition should be distinguished from technical
default. Legally, any nonpayment of a scheduled mortgage payment places a mortgage in
technical default (Giliberto and Houston 1989, p. 56).
4
In addition to the value of the debt and the costs of foreclosure, that is, the legal act that
extinguishes the borrowers right of redeeming the mortgage property, lenders also consider
whether or not the loan has been securitized. As an anonymous referee correctly pointed out,
the ability of the lender to forbear or restructure the loan is generally eliminated if the loan
has been securitized.
5
In states where nonjudicial foreclosure is available, lenders may accept a deed in lieu of
foreclosure as a means of minimizing losses.
344 Roberto G. Quercia and Michael A. Stegman
payment was restarted) and those that ended up in default (foreclosure
occurred). If foreclosure does occur, the timing of default can be set
retroactively to the first payment missed. This assumption has allowed
researchers to analyze the behavior of defaulting borrowers in a large
number of published studies.
The number of default studies is also largely attributable to the availabil-
ity of public aggregate and disaggregate loan data on residential borrow-
ing and default (Simons 1990). Unfortunately, the available information
is collected by lenders at the time of loan origination (ex-ante data) and
is not the more desirable information contemporaneous with (at the time
of) the default decision (ex-post data). Data contemporaneous with the
default decision have been estimated through the use of proxy and other
measures.
6
In this article, default studies are divided into three groups: first-,
second-, and third-generation studies. The studies vary in three respects.
First, each study chooses a perspective from which mortgage risk is
analyzed: lender, borrower, or institutional. A second aspect is the
different measures studies use to determine mortgage risk: mortgage
interest rate premiums, default rates, delinquency rates, or expected
mortgage losses. Finally, studies follow one of two primary research
approaches, that is, they make either a theoretical or an empirical
contribution to the literature.
7
The last section of this article presents an
overall discussion of the state of residential mortgage default literature
and suggests directions for future research.
First-Generation Studies: the Lenders Perspective
An important stream of literature, beginning in the 1960s and extending
through the present, addresses default principally from the perspective
of the individual mortgage lender. Relatively light on formal theory,
these empirical studies attempt to identify the characteristics of both
mortgages and borrowers at the time of loan origination that could be
highly correlated with mortgage default later in the loan term. The early
6
The use of the expressions ex-ante and ex-post is not fully adequate. These expressions mean,
literally, out of what came before and out of what came afterward, respectively. These
meanings do not capture the nature of data at time of loan origination or contemporaneous with
the default decision. Better terms are needed. To be consistent with the literature, both
expressions will be used in this article.
7
The inclusion of individual studies in a given generation is advanced for presentation
purposes only. Although every study has innovations that could place it in any of the
generations, the central aspects of studies were used to group them into the three generations.
Ultimately, the evolution of default studies over the last three decades has been a continuum,
with each new study expanding our previous understanding of mortgage risk, in general, and
the default decision, in particular.
Residential Mortgage Default: A Review of the Literature 345
works of Jung (1962), Page (1964), and von Furstenberg (1969), among
others, evaluated the relationships between mortgage risk and charac-
teristics of the mortgage loan, including the loan-to-value ratio, interest
rate, and mortgage term. Subsequent research extended this analysis of
mortgage risk to include an array of borrower (von Furstenberg 1969;
Herzog and Earley 1970; Sandor and Sosin 1975) and property (von
Furstenberg and Green 1974) characteristics. (See table 1 for a summary
of these early studies.)
The Role of Loan Characteristics
The first predictive studies of default evaluated the default expectations
that lenders assign to mortgage risk as represented by loan characteris-
tics, especially mortgage interest rate premiums charged for loans
considered risky.
8
The basic premise of these studies was that because
interest rates charged to borrowers reflect the expectations that lenders
hold toward mortgage risk, and because the risk of default increases with
a higher loan-to-value ratio, interest rates should have a positive corre-
lation with the loan-to-value ratio at the time of origination (Jung 1962).
Page (1964) provided empirical support for this premise as well as the
contention that interest rates also vary with other terms of financing.
9
The term of the loan and property value were found to be negatively
correlated with mortgage interest rate. The inverse relationship be-
tween mortgage interest rate and property value may indicate that only
more stable and better borrowers can purchase high-value properties
and are therefore considered to be low risk by lenders (Sandor and Sosin
8
Four early studies, descriptive in nature, examined the default and/or delinquency decisions.
These studies were the U.S. Veterans Administrations Report on Loan Service and Claims
Study (1962), the U.S. Federal Housing Administrations FHA Experience with Mortgage
Foreclosures and Property Acquisitions (1963), the U.S. Housing and Home Finance Agencys
Mortgage Foreclosures in Six Metropolitan Areas (1963), and the U.S. Savings and Loan
Leagues Anatomy of the Residential Mortgage (1964). These studies suggested that delin-
quency and foreclosure rates vary directly with loan-to-value ratio, mortgage interest rate,
housing expense-to-income ratio, and number of dependents, and inversely with age of the
loan, home equity, purchase price, age of borrower, and borrowers occupational skill level.
Also, these studies indicated that loans involving junior financing or refinancing are riskier
than other loans. Unfortunately, none of these studies performed tests of statistical signifi-
cance, and thus no basis exists for determining whether the relationships observed have any
real meaning or whether they largely reflect random variation (Herzog and Earley 1970,
pp. 3940).
9Using aggregate data from 31 savings and loans institutions, Jung (1962) had shown already
that interest rate and loan-to-value ratio were positively correlated, but given the small sample
size, he was unable to perform tests of statistical significance. Using multivariate regression
analysis, Page (1964) found the debt-to-equity ratio (purchase price to purchase price minus
loan amount) to be a better predictor of mortgage interest rate premiums than the comparable,
but somewhat different, initial loan-to-value ratio used by Jung. Sandor and Sosin (1975)
found both measures to be good predictors of mortgage interest rate premiums.
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348 Reberto G. Quercia and Micheal A. Stegman
Residential Mortgage Default: A Review of the Literature 349
1975). In these first studies, mortgage risk, as it translates into mortgage
interest rate premiums, was considered exclusively as a characteristic of
the loan.
10
The first studies on actual default were undertaken in the late
1960s and early 1970s. In these studies, rational homeowners who have
to move are assumed to contemplate the default option if they expect
their equity in the home to be negative, net of costs such as sales
commission, and are prepared to suffer a lower credit rating and the
stigma of immorality of default (von Furstenberg 1969).
Evidence of the importance of home equity to actual default behavior is
present in these early studies. Using aggregate data from a sample of
Federal Housing Administration (FHA) and Veterans Administration
(VA; now the Department of Veterans Affairs) mortgages, von Furstenberg
(1969, 1970a, 1970b) found that home equity at the time of origination
was the most important predictor of default risk. For instance, when
loan-to-value ratios are raised from 90 to 97 percent, default rates for
new homes increase sevenfold.
Other loan characteristics were also found to be important determinants
of mortgage risk. Mortgage risk increases with the term of the loan
11
and
with the age of the mortgage up to year 3 or 4 after origination, after
which it declines (von Furstenberg 1969). Finally, the presence of
secondary or junior financing is also an important determinant of
delinquent loans (Herzog and Earley 1970).
12
The Role of Borrower-Related Factors
Compared with loan characteristics, borrower-related factors do not
present such a clear-cut measure for default. For instance, although
default rates rise rapidly as mortgagor income falls, it can also be shown
that loan-to-value ratio rises as income falls (typically, low-income
families can afford only minimal down payments). Thus, when von
Furstenberg (1969) found household income to have a significant effect
10
Page (1964) also included one property characteristic in his study: whether the unit was new
or existing. He estimated his model for both new and existing homes with similar results.
11
Von Furstenberg (1969) found, for instance, that a 30-year mortgage on a new home is eight
times as risky as a comparable 20-year mortgage. In contrast, Herzog and Earley (1970) found
that once the effects of other variables are removed, the term of the mortgage has little or no
significance as a determinant of delinquent loans.
12
Herzog and Earley (1970) found the presence of secondary or junior financing the most
important factor in explaining mortgage default and delinquency. Consistent with prior
work, the authors found loan-to-value ratio and loan purpose to have significant effects on
default and delinquency. In contrast, term of the mortgage was found to have an effect on
default but not on delinquency, while region of the country was found to have an effect on
delinquency but not on default.
350 Roberto G. Quercia and Michael A. Stegman
on default, he believed that the effect was actually capturing the effect of
loan-to-value ratio on default.
13
In their analysis of mortgage delinquency, Herzog and Earley (1970)
examined the role of other borrower-related factors on delinquency.
Neither borrower age, marital status, nor number of dependents was
found to have an effect on delinquency or default.
14
Also, mortgage
payment-to-income ratio at the time of origination was not found to be
significant, a finding confirmed by Morton (1975) and Sandor and Sosin
(1975). This fact can be attributed to lending practices that watch this
ratio very carefully and deny loans that exceed some critical threshold at
time of origination (Herzog and Earley 1970).
15
In contrast to the continuous measure considered in prior work,
Williams, Beranek, and Kenkel (1974) included payment-to-income ratio
information in categorical form in their analysis of the default decision.
In this form, borrowers with an initial payment-to-income ratio higher
than 30 percent were significantly more likely to default than were other
borrowers.
Unlike other borrower-related factors, the variability of household in-
come shows a consistent effect on mortgage default and delinquency. In
their analysis of mortgage delinquency, Herzog and Earley (1970) exam-
ined the impact of income variability, captured by the proxy measure of
occupation, on troubled loans. Borrowers in occupations with greater
income variability at the time of loan origination were found to be more
likely to be delinquent than other borrowers. For instance, self-employed
people and salespeople, whose incomes exhibit the greatest variability
(Webb 1982), are more likely to be delinquent than are professional
people and executives, whose income is less variable.
The Role of Property Characteristics
In addition to confirming the importance of loan characteristics and
suggesting a number of borrower-related factors for further analysis,
13
In comparing the effects of loan and borrower characteristics on default, von Furstenberg
(1969) concluded that loan-to-value ratio explains 32 percent of the total variation in annual
default rates, while household income, by itself, explains less than 10 percent (p. 477).
14
In contrast, in his discriminant analysis of the delinquency and default decisions, Morton
(1975) found the presence of five or more dependents to have a significant and positive
effect on both delinquency and default.
15
This fact would limit the variance in this continuous variable to such a narrow range that
it would likely minimize its significance in a regression model. However, the use of
alternative payment-to-income measures could lead to different conclusions.
Residential Mortgage Default: A Review of the Literature 351
later studies assessed local real estate markets and property conditions as
factors in default risk. Loans made in suburban locations were found to be
less risky than those made in central-city locations (von Furstenberg and
Green 1974).
16
Areas with high unemployment rates were found likely to
have higher loan default rates (Williams, Beranek, and Kenkel 1974).
17
Finally, good condition of property and neighborhood were negatively
correlated with mortgage interest rate premiums (Sandor and Sosin 1975).
Extension of Early Study Findings
Their contributions to the identification of important loan, borrower,
and property characteristics aside, most first-generation studies suf-
fered from three limitations. With the primary focus of identifying risky
loans at the time of loan origination, researchers did not consider the
actual time frame of default and the importance of factors existing when
the default decision was made. Second, because of data limitations,
researchers relied on the use of proxy measures, such as occupation for
income variability, to capture the effect of factors believed to affect a
households ability to pay and its equity position. Finally, researchers
focused on the default decision of borrowers holding fixed-rate mort-
gages (FRMs) exclusively, because this was the only type of mortgage
instrument available at that time.
Vandell (1978), Webb (1982), Zorn and Lea (1989), and Cunningham and
Capone (1980) extended the default analysis to other mortgage instru-
ments. Vandell (1978) also considered the timing of default and the effect
of contemporaneous net equitythe ratio of contemporaneous book
value of the loan to contemporaneous value of the propertyon the
default decision. He contended that borrower-related effects are also
important, especially events such as loss of employment, death, and
divorce.
18
Overall, Vandell found support for his theories, except for the
16
In their cohort analysis of 7,609 loans originated by a Pittsburgh, Pennsylvania, mortgage
lender, von Furstenberg and Green (1974) found that a suburban location reduces delinquency
risks significantly (by as much as 47 percent) compared with an urban location.
17
In their comparative analysis of default among seven lending institutions in Pittsburgh,
Williams, Beranek, and Kenkel (1974) found that the unemployment rate has a significant
positive effect on default. In contrast, they found that area crime, captured with the proxy
measure per capita changes in crimes against property, had no effect on default rates.
18
Specifically, Vandell (1978) contended that borrower-related effects include the level of
borrower consciousness towards repayments or the likelihood of occurrence of a seriously
destabilizing incident such as unemployment, death, and divorce, which would render default
more likely (p. 1285). Vandell used the proxy measure household income to capture these
effects. He also included a transient time term designed to capture the borrowers initial effort
to make mortgage payments. He believed this time term to be a function of borrower
characteristics, especially the level of liquid assets at the time of loan origination.
352 Roberto G. Quercia and Michael A. Stegman
importance of borrower-related effects on default.
19
The estimation of
contemporaneous borrower information from ex-ante data may explain
this lack of borrower effect, as the national and regional indices used in
this estimation may not have captured the individual circumstances of
borrowers who default.
On the basis of his findings, Vandell simulated the default risk under
alternative mortgage instruments.
20
Under normal circumstances, such
as a 20 percent down payment and a unit that was appreciating in value
and located in a stable neighborhood, all instruments performed about
the same. Under worse conditions, such as a low down payment or no unit
appreciation, mortgage risk increased under all instruments, including
FRMs. Increases in risk, however, were found to be particularly severe
under the price-level-adjusted mortgage (PLAM) and graduated-pay-
ment mortgage (GPM).
Unlike Vandell (1978), who used simulations, Zorn and Lea (1989)
estimated a model of mortgage borrower behavior using actual indi-
vidual loan data aon Canadian borrowers with rollover mortgages, a form
of adjustable-rate mortgage (ARM). Their multinomial logit estimation
confirmed the implicit assumption of previous studies: The default
behavior of FRM and ARM borrowers is similarly motivated. Given the
importance of equity and mortgage interest rate in the default decision,
Zorn and Lea inferred that the default risk of ARMs in the United States
is likely to be higher than that of FRMs because mortgage-related
capital gains are less likely with frequently adjusting ARMs, and that,
by design, ARMs have the potential for higher real mortgage interest
rates (p. 131).
21
The only study of the default experience among U.S. borrowers hold-
ing alternative mortgage instruments is a recent one by Cunningham
and Capone (1990). The authors analyzed the mortgage termination
19
Using ex-ante data to estimate the necessary ex-post information, Vandell (1978)
respecified the default model developed by von Furstenberg (1969,1970a, 1970b). Vandells
findings are consistent with those of prior work. He found contemporaneous net equity to
be of great importance in affecting default risk. Also consistent with von Furstenberg,
Vandell found household income to be statistically not significant, thus giving no support
to the importance of borrower-related effects.
20
A later study by Webb (1982) also used simulation methodology to analyze potential
delinquency under different mortgage instruments.
21
In their analysis, Zorn and Lea (1989) estimated the concurrent probabilities of the
continue payment, prepay, become delinquent, and default alternatives that borrowers
have each payment period.
Residential Mortgage Default: A Review of the Literature 353
experience of a sample of ARM and FRM borrowers.
22
Expanding on prior
work, they included a set of ARM-specific determinants to isolate unique
mortgage termination behavior under ARMs. Large lifetime caps were
found to be positively related to default under ARMs, whereas long
adjustment periods were found to be inversely related. When interest
rate movements exceeded lifetime cap limits, caps were also found to
have a secondary effect on default probabilities, because ARMs with low
caps become more desirable when interest rates rise substantially above
the cap limit.
23
Using mean-based simulation analysis, the authors
concluded that ARMs are more sensitive to variable changes and have,
overall, a greater default risk than FRMs.
24
In summary, the first-generation studies offer the first insights on
residential mortgage default risk. They provide evidence of the impor-
tance of loan characteristics, such as equity, on default, and they suggest
a need to examine further the role of borrower-related factors in default.
They also suggest that loan and borrower information should be collected
and considered at the time of mortgage default and not just at loan
origination. Overall, these early studies have one common purpose: to
assist lenders in predicting the default decisions of borrowers. Generally,
no attempt is made to provide a theoretical basis for borrower behavior
at the time of default. In contrast, the second-generation studies seek to
explain borrowed behavior through a structured model.
Second-Generation Studies: the Borrower's Perspective
Beginning in the late 1970s, a second generation of empirical default
studies, rooted in the economic theory of consumer behavior, emerged.
Rather than informing the lender about loan and borrower characteris-
tics associated with default, such studies model the behavior of indi-
vidual households that, in the course of maximizing their utility (and net
wealth) over time, rationally decide whether it is in their best interest to
continue making payments on their mortgage loans. This research also
views the default decision within a broader framework, a borrower
payment model that includes the simultaneity of mortgage payment
decisions. (See table 2 for summary of this research.)
22
Using data from 879 loans from a mortgage banking firm in Houston, Texas, and a
multinomial logit estimation, Cunningham and Capone analyzed the concurrent default
and prepayment decision of 411 borrowers holding ARMs and 469 borrowers holding
FRMs.
23
Likewise, when rates fall substantially borrowers terminate more quickly [prepay] to
avoid cap restrictions (Cunningham and Capone 1990, p. 1697).
24
Cunningham and Capone found the reverse to be true for prepayment. For instance,
interest rate expectations were found to have a stronger effect on FRM than on ARM
prepayment behavior.
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354 Roberto G. Quercia and Michael A. Stegman
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Residential Mortgage Default: A Review of the Literature 355
356 Roberto G. Quercia and Michael A. Stegman
Borrower Payment Model
The borrower payment model used in most second-generation studies of
default is an optimization model of borrower choice. At each payment
period during the life of the mortgage, borrowers have four choices. They
can make the scheduled mortgage payment, delay payment (become
delinquent), stop payment altogether (default), or prepay the mortgage
through refinancing or the sale of the property. Borrowers are assumed
to assess the utility derived from each of the four alternatives separately
and to choose the outcome that maximizes their utility over time, given
their circumstances. A central aspect of this model is the simultaneity of
mortgage payment decisions.
25
25
In technical terms, a borrower is assumed to maximize a utility function defined over
a vector of mutually exclusive qualitative choices, S, and a vector of exogenous state
variables, X. It is assumed that the utility-maximizing choice can be represented as a
probability function of the other state variables, P(s
i
|X) = f
i
(X ), where the sum of the
probabilities of all n elements in S for a given X is equal to unity (Campbell and Dietrich
1983). McFaddens (1973) variation on random utility models has been used to derive these
probabilities (e.g., Campbell and Dietrich 1983; Zorn and Lea 1989). Given that the
borrower can choose among continuing payment, delaying payment, defaulting, or
prepaying, a multinomial logit estimation, in which the default decision is viewed as a
particular form of mortgage payment outcome (Zorn and Lea 1989; Cunningham and
Capone 1990), is ideal. Borrowers are expected to default if this outcome maximizes their
after-tax real wealth in the terminal period. For instance, the payoff function if borrowers
choose to default can be expressed as follows (Vandell and Thibodeau 1985, pp. 295296):
The payoff function if borrowers choose to continue payment can be expressed as follows:
where
WD = payoff function if borrower defaults;
W
C
= payoff function if borrower continues payment;
Y = real annual after-tax household income;
R = required real nondiscretionary expenditures (other than housing);
Q
r
= required real rent on new unit (gross rent plus utilities, etc.);
i

r = expected real return on nonhousing investments;
W = current real nonhousing wealth;
Q = required real after-tax payment on mortgage (plus taxes, insurance, and other
ownership costs);
r
0
= expected opportunity cost of borrowing or return on lending
(r
0
= r
i
if Y R Q 0 or r
0
= r
b
if Y R Q < 0);
V
T
= expected real market value of current home; and
L
T
= expected real outstanding loan balance on current mortgage.
Borrowers are expected to choose to default rather than continue payment if W
D
is greater
than W
C
.
(1)
Residential Mortgage Default: A Review of the Literature 357
Optimization model of default. Jackson and Kasserman (1980) were the
first to test and confirm the adequacy of an optimization model of
consumer choice in the analysis of default decisions. The authors explic-
itly formulated and tested two competing hypotheses: the net equity
approach, based on an optimizing mode of behavior; and the ability to pay
(i.e., cash flow) approach. In the first approach, borrowers base their
default decision on a rational comparison of the financial costs and
returns involved in continuing or terminating mortgage payments. If
home equity is negative after all costs and benefits are considered,
borrowers will choose to default. In the second approach, borrowers
default if their income flow becomes insufficient to meet the periodic
payments without undue financial burden. Jackson and Kasserman
hypothesized that loan-to-value ratios and the mortgage interest rate are
positively related to default in both scenarios, whereas the term of the
mortgage is positively related to default only under the net equity
approach. Using ex-ante data from 1,736 FHA Section 203(b) loans, the
authors found support for the net-equity-maximization model of default
over the ability-to-pay model.
In their multiperiod model of consumer choice, Campbell and Dietrich
(1983) extended Jackson and Kassermans work on the importance of net
equity in the borrowers decision to default. Both original and contempo-
raneous loan-to-value ratios were found to have significant positive
effects on the default decision, providing evidence of the importance of
home equity level at the time of the default decision.
26
One borrower-related
factor, income variability, captured by the proxy measure regional unem-
ployment rate, was found to have a significant positive effect on default.
27
Option-based model of default. In the mid-1980s a narrower concept-
ualization of the default decision was proposed in the form of an option-
based model of default. This model views default as a put option, allowing
the borrower to sell the house to the lender for the value of the mortgage
at the beginning of each payment period (Foster and Van Order 1984).
28
In assessing whether or not to exercise the option, borrowers consider the
26
Consistent with prior work, Campbell and Dietrich (1983) also established that loans
on new homes are riskier than loans on existing homes. Also, age of mortgage was found
to have a nonlinear relationship with default. Yet the authors cautioned about interpret-
ing the effect of age of mortgage directly. They contended that the underlying determi-
nants of default cannot be measured with adequate precision today because of data
limitations that impede isolation of any independent age effect.
27
Campbell and Dietrich (1983) found that the initial mortgage payment-to-income ratio
exhibited too little variation up front to be included in the model. The authors attributed
this lack of variation to the fact that lenders review this ratio carefully at the time of loan
origination, denying loans that exceed a certain critical threshold. The use of an aggregate
income index to estimate contemporaneous, ex-post information from ex-ante data may
also reduce variability of this ratio over time.
28
Similarly, prepayment can be viewed as a call option, allowing the borrower to exchange
a sum of money for the mortgage instrument.
358 Roberto G. Quercia and Michael A. Stegman
market value of the mortgage and the equity they have in the home,
which is a crude measure of the extent to which the put option is in the
money (Quigley and Van Order 1991). From this perspective, default is
seen as a purely financial matter, in which borrower characteristics such
as income and employment status do not matter.
Ideally, borrowers will exercise this option, and thus default, whenever
the value of the house plus any costs of exercising the option falls below
the mortgage value (Foster and Van Order 1984). However, because the
default option has intrinsic value and the current value of the mortgage
is affected by the option to default in the future, some borrowers with
negative equity may not default because they would forfeit the option of
defaulting later (Epperson et al. 1985). This factor makes it difficult to
compute the value of the option.
A second issue that makes this computation complex is the problem of
estimating the costs of exercising the default option. Borrowers are
assumed to consider costs such as transaction costs, moving costs, and
the value of the borrowers reputation and credit rating, which are also
affected by default (Quigley and Van Order 1991).
Foster and Van Order (1984) were the first to apply option theory
formally to the field of mortgage default by significantly extending
Campbell and Dietrichs work. Using data on FHA 203(b) default rates
from 1960 through 1978, Foster and Van Order (1984) estimated loan-
to-value ratios over time and used this information to create a number
of variables that represented the percentage of loans with negative
equity for each year in the study period. These equity variables were
included in the regression model in current and lagged form. Overall, the
option-based model of default worked remarkably well: It explained over
90 percent of the variance using just the equity variables.
The significance of the lagged equity terms indicates that the default
option is not exercised immediately. Given a borrower with negative net
equity, Foster and Van Order (1984) contended, an event such as a
divorce or loss of employment may be needed to trigger a default. There
was no empirical support for this contention.
29
Ultimately, Foster and
Van Order attributed the imperfect exercise of the option to the impor-
tance of transaction costs, which were captured inadequately in their
study. Foster and Van Order (1985) later found that borrowers do not
29
In trying to explain this imperfect exercise of the default option, Foster and Van Order
(1984) reestimated their model with a number of variables suggested by prior work:
divorce rate, unemployment rate, expected inflation, age of loan, and mortgage payment-
to-income ratio. Overall, none of these variables contributed much to the model.
Residential Mortgage Default: A Review of the Literature 359
exercise the default option consistently, even under zero transaction costs
or with negative equity.
30
The Role of Transaction Costs, Crisis Events, and Expectations
Vandell and Thibodeau (1985) also addressed the issue of transaction
costs and crisis events. The authors extended Campbell and Dietrichs
(1983) and Foster and Van Orders (1984) models of consumer choice,
using option-based modeling to include local market conditions that
affect property values: the occurrence of crisis events and transaction
costs.
31
Unlike the previous authors, Vandell and Thibodeau also consid-
ered the importance of the contemporaneous market value of the loan, as
opposed to its contemporaneous book value, and used individual loan
history data in their analysis. They also considered the role of expectation
in the default decision by modeling expected home values with a weighted
index of backward-looking adaptive factors (Simons 1990).
32
30
Foster and Van Order (1985) also acknowledged what they called the simultaneity
problem. Specifically, they stated that an owner with negative equity with a mortgage
evaluated at par might not default because he forfeits the option of defaulting later, which
is to say he is getting more insurance than he is paying for, and he may choose to keep
getting the cheap insurance (p. 280). This simultaneity is difficult to estimate. Fortu-
nately, the use of FHA loans in their analysis allowed the authors to control for this effect,
because FHA charges the same price for all insurance, subject to a minimum down
payment, Hence the excess value of insurance is approximately the new, minimum
downpayment that would have to be made on the house, assuming the defaulter simply
repurchases a similar house after default. Foster and Van Order took the value of the
mortgage to be the present value of remaining payments, given a standard prepayment
assumption, and they included the minimum down payment as a part of the cost of default
(p. 280).
31
Because of data limitations, Vandell and Thibodeau (1985) used a number of proxy
measures to capture the significance of transaction costs and the occurrence of crisis
events that may trigger, delay, or eliminate the need to exercise the default option.
32
Vandell and Thibodeau (1985) considered the role of borrower expectations on the default
decision in a manner consistent with prior work. For example, Jackson and Kasserman (1980)
indicated that borrowers considered future expected property values when assessing their
equity position in their multiperiod optimization model. When expectations are considered,
a borrowers equity position can be captured with a measure of expected net equity (NETEQ).
At time t, this measure can be expressed as the following function (Simons 1990, p. 135136):
E[NETEQ]
t
= E[MVP CT SC LI OPB PAR]
t
where
MVP = expected market value of the property at time t;
CT = capital gains tax on sale of the property at time t;
SC = sales commission to an outside agent;
LI = reduction of borrower equity attributable to recognition of all outstanding
nonmortgage liens against the property;
OPB = outstanding principal balance of the mortgage; and
PAR = expected financial value to the borrower of the current difference between the
contracted mortgage rate and the prevailing mortgage rate, weighted by the
outstanding principal balance.
360 Roberto G. Quercia and Michael A. Stegman
Using economic theory, Vandell and Thibodeau (1985) formally devel-
oped a two-period maximization model of consumer choice that included
borrowers expectations. At each payment period, the borrower is as-
sumed to choose one of five outcomes: to default on the mortgage, to
become delinquent, to prepay through refinancing, to repay through sale,
or to make the scheduled payment. Borrowers are expected to choose the
outcome that maximizes after-tax real wealth in the terminal period. For
instance, borrowers are expected to choose to default rather than con-
tinue payment if their real after-tax wealth in the terminal period will be
greater if they default.
In their empirical analysis, Vandell and Thibodeau analyzed the default
decision exclusively.
33
Consistent with the contentions of their model,
the authors found contemporaneous net equity to have a significant
positive effect on default, whereas the difference between market and par
value of the mortgage exhibited a significant negative effect.
These two variables, however, have a smaller effect on default than do the
variables representing source of income. Vandell and Thibodeau (1985)
found that an increase in initial loan-to-value ratio from 75 to 95 percent
has an effect on default risk that is only about 1/14 as large as the effect
of being self-employed. Similarly, they found that reducing the difference
between market value and the par value of the mortgage to zero has
an effect only 1/10 as large as the effect of being self-employed (p. 312).
On the basis of these results, Vandell and Thibodeau simulated default
rates under different risk scenarios. Under normal circumstances, they
estimated that the probability of default in the presence of a 10 percent
expected negative net equity at year 5 after origination was only
1.75 percent.
34
Contrary to the contention of the option-based model of
default, nonequity factors seem to play an important role in the default
decision.
33
To our knowledge, only two studies have estimated the concurrent continue payment,
prepay, or default decision confronted by borrowers at each payment period. Cunningham and
Capone (1990) used a multinomial logit estimation to analyze the concurrent loan termination
experience of borrowers holding FRMs and ARMs, and Zorn and Lea (1989) undertook a similar
analysis on a sample of Canadian borrowers holding rollover mortgages, a form of adjustable-
rate mortgage. Zorn and Lea also analyzed the delinquency decision.
34
Vandell and Thibodeau (1985) found that several borrower-related factors significantly
affect default. Variables such as self-employment, sources of income from commission and
investment, a short length of employment, and low nonhousing wealth at time of loan
origination (i.e., variables capturing low permanent income), were associated with riskier
loans. Surprisingly, payment burden had a negative effect on default. The authors suggested
that this effect might be due to stricter appraisal standards or underwriting practices that
permitted high payment-to-income-ratio loans only to those borrowers with ample additional
resources to overcome default (p. 313). Neighborhood quality also had a significant negative
effect on default.
Residential Mortgage Default: A Review of the Literature 361
Overall, the theoretical premises set forth by Vandell and Thibodeau
(1985) and other second-generation studies constitute the basis for the
current state of theory. The examination of the default decision as an
option and the central role of net equity constitute the dominant view in
all recent default studies. Second-generation studies also provide some
evidence about the importance of transaction costs and borrower-related
factors such as borrowers expectations and occupation. Finally, al-
though there are conceptual justifications for the relevance of crisis
events on the default decision, second-generation studies provide little
direct empirical correlation. This and other issues were further consid-
ered in the third generation of research.
Third-Generation Studies: the Institutional Perspective
The high rates of default on mortgage loans originated in the late 1970s
and early 1980s stimulated the birth of a third generation of research on
mortgage defaults, which viewed default mainly from an institutional
perspective. Because of the large loan volumes involved in FHA, Fannie
Mae, and Freddie Mac operations and the need to price mortgage credit
to anticipate losses from default, this research is more concerned with
estimating the probability that a particular fraction of a large loan pool
will default than it is with modeling individual borrowers default
decisions. The contribution of most third-generation studies is in large
part methodological, both in terms of examining measures of default risk
that better reflect institutional concerns and in the use of sophisticated
estimation techniques, such as proportional hazard estimation of default
probabilities. (See table 3 for a summary of third-generation studies.)
Expected Losses and Default Rates
From the perspective of lenders and investors (both of which can be
institutions), default rates are not an adequate measure of mortgage
risk. For instance, default rate is an inappropriate measure of risk if the
purpose of the analysis is to establish a premium for mortgage default
insurance, to estimate the costs of default on a government subsidy
program, or to establish a mortgage interest rate premium on a category
of loans (Evans, Maris, and Weinstein 1985). This is because the propor-
tion of dollars loaned that become losses in default varies by loan, a fact
that is not captured when default rates are considered.
35
Thus, a
measure of expected mortgage loss is a better indicator of mortgage risk
than are default rates.
35
Thus there are significant differences in risk even among defaulted loans.
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Residential Mortgage Default: A Review of the Literature 363
364 Roberto G. Quercia and Michael A. Stegman
One study has analyzed the determinants of both mortgage loss and
default rates. Evans, Maris, and Weinstein (1985) found high initial loan-
to-value ratios riskier in terms of both default rates and expected
losses.
36
In contrast, loan amount had no effect on default rates but did
have a significant negative effect on expected loss. Similarly, although
loans made to African-American borrowers were found to be riskier than
those made to other borrowers on both measures, the magnitude of the
difference was smaller on expected loss than on default rates. Loans
made to African-American borrowers had 7.47 percent more defaults
than those made to other borrowers, yet the expected loss difference
among these borrowers was only 2.35 percent.
37
These findings suggest
that from an institutional perspective, expected losses may be a better
measure of default risk than default rates, because expected losses
provide a more accurate basis for estimating mortgage insurance premi-
ums, mortgage interest rate premiums, and the potential default costs of
a government subsidy program.
Foreclosure: the Lender' Decision to Minimize Losses
The foreclosure costs faced by lenders are an important consideration in
estimating the expected loss resulting from mortgage default. Foreclo-
sure costs are affected by several factors.
38
First, foreclosure costs are
lower in states where there is nonjudicial foreclosure, such as power-of-
sale foreclosure, foreclosure by advertisement, or a trustees sale (Clauretie
1987). Where nonjudicial foreclosure is available, a third party such as
a lawyer or a foreclosing service conducts the sale of the foreclosed
property. In these states, lenders can avoid the more costly court-
supervised foreclosure. Also, costs are lower where there is an absence of
statutory right of redemption, which allows borrowers to redeem their
properties after the foreclosure sale for the amount paid at the sale. Costs
are also lower where deficient judgment is allowed, which permits
lenders to recover directly against the borrowers personal assets.
Finally, foreclosure costs decrease in states with shorter foreclosure and
36
In a recent study, Clauretie (1990) also found that the loss rate on defaulted loans
increases with loan-to-value ratio. Clauretie contended that an adequate measure of
mortgage risk is the dollar loss per amount originated. This dollar loss is the product of
the default rate and the loss rate on defaulted loans (p. 203).
37
Evans, Maris, and Weinstein (1985) performed a risk-return analysis considering factors
such as loan characteristics, borrowers race, and location. Using information from the
FHA Mortgage Cross Reference File, the authors found that the magnitude of the effects
of loan characteristics and race on expected loss and default rate was distinct among
groups of loans. However, in contrast to prior studies of default rates, they found suburban
and urban location (other than central city) to have no effect on either default rates or
expected loss.
38
The presentation in this section follows Clauretie (1987).
Residential Mortgage Default: A Review of the Literature 365
redemption periods (i.e., the period of time borrowers have to exercise
their right of redemption). Foreclosure costs are important to the lenders
decision to foreclose rather than renegotiate a loan.
In his analysis of the foreclosure decision by lenders, Clauretie (1987)
found that foreclosure is more likely in states where costs are lower.
39
In
states where legal costs are high, lenders appear more willing to work with
slow or delinquent borrowers. In such cases, however, lenders may also incur
losses as a result of the negotiation. Thus, Clauretie concluded, interstate
foreclosure rates reflect the choice of the least-cost method of limiting
losses by lenders when dealing with slow or delinquent loans (p. 165).
Default Risk and Capital Requirements
An estimation of expected losses and mortgage risk is indispensable in
assessing the capital requirements of lenders and the institutions
insuring these mortgages. Erosion of reserves in the FHA Mutual
Mortgage Insurance Fund in the late 1980s prompted an actuarial
analysis of the fund, which was conducted by Price Waterhouse (1990).
Given that defaulted loans make claims on the reserve fund, Price
Waterhouse developed economic models to explain the probability of
claim and nonclaim loan terminations and to forecast future claims on
the fund by analyzing the default experience of FHA loans.
40
The results of Price Waterhouses contingency claims analysis were
consistent with those of prior work. The level of home equity, captured
with loan-to-value ratio, was found to have a significant effect on claim
rates. This effect, however, varied across loan-to-value ratios. As loan-to-
value ratio increased, the negative effect of equity also increased. There
39
Clauretie (1987) also found that in states with high foreclosure costs, lenders are more
likely to make loans on risky properties only if they are underwritten by federal agencies.
In his analysis, Clauretie used foreclosure data on conventional FHA and VA loans, by
state, from the member institutions of the Mortgage Bankers Association (19761985) and
the Federal Home Loan Bank System (19761983).
40
Using a framework similar to the one proposed by Vandell and Thibodeau (1985), Price
Waterhouse estimated claim rates due to loan termination through default. Default rates
were expressed as a function of the level of equity (loan-to-value) and a number of economic
conditions. Consistent with prior work, default is expected to occur with high initial
mortgage loan-to-property-value ratio because a high ratio provides little cushion against
default when property values decline. Similarly, risk increases when the value of the
mortgage rises above the remaining mortgage balance, which occurs when the current
interest rate falls below the original contract rate. Thus, both a sharp decline in property
value and prevailing interest rates below the contract rate could lead to default. Borrowers
may also consider the default decision if they desire or are forced to move by events such
as divorce or loss of employment. Data from a pool of FHA-insured 30-year fixed-rate loans
originated between 1975 and 1989 were used in the analysis. Price Waterhouse also
estimated and analyzed claim rates due to loan termination through prepayment.
366 Roberto G. Quercia and Michael A. Stegman
was a pronounced increase in claims when loan-to-value ratio was above
90 percent, and even a further escalation when it exceeded 95 percent.
Conversely, loan size was found to have a significant but negative effect
on claims. That is, smaller loans were found to be riskier than bigger
loans, reflecting the fact that only high-income borrowers may qualify for
large loans.
41
Thus, the characteristics of loans are crucial in estimating risk of losses
in loan pools. In assessing the effectiveness of the estimates, Price
Waterhouse found that 96 percent of the actual number of FHA claim
terminations from 1979 to 1987 were predicted accurately. Consistently,
the pattern of claims forecast for the period from 1988 to 1990 was easily
explained by differences in loan composition. The sharp increase in
predicted claim terminations in 1988 and 1989 was attributable to the
move toward higher loan-to-value ratio on FHA loans. The decline in
predicted claims in 1990 was attributable to the fact that the simulation
used a larger loan amount, which, by law, requires a lower initial loan-
to-value ratio.
42
The risk of losses in large loan pools and the resulting capital require-
ments for lenders were also examined by Quigley and Van Order (1991).
43
Loan-to-value ratio and geographic diversification were found to have
significant effects on risk. Institutions holding loans with initial loan-to-
value ratios between 81 and 90 percent required one-third of the capital
required by institutions holding loans with ratios between 91 and 95
percent.
44
Similarly, a nationally diversified lender was found to need
only one-half of the capital required of a regionally based lender (p. 354).
This disparity suggests that capital requirements for lending institu-
tions need to be set by loan characteristics such as loan-to-value ratio and
by geographical diversification.
41
Other variables considered in the claim analysis were also found to have a positive
impact on loan termination through default. For instance, unemployment rate, lagged one
year, had a positive impact on claims. As was the case with home equity, the effect of
unemployment rate on claims increased with loan-to-value ratio. Also, age of mortgage
was found to have a nonlinear effect on claims. Consistent with prior work, claims caused
by default peaked in the fourth year after origination and declined afterward (Price
Waterhouse 1990).
42
The larger loan amount used in the 1990 simulation is the result of an expanded ceiling
allowed for loans originated that year.
43
Using data from 300,000 conventional loans originated from 1976 through 1980 and
bought by Freddie Mac, Quigley and Van Order estimated mean returns and their
variances and covariances, that is, the risk associated with the return, for various loan-
to-value and geographical groups.
44
In assessing the adequacy of the 3 percent capital requirement for 30-year FRMs with
low loan-to-value ratios, Quigley and Van Order (1991) concluded that this requirement
is excessive and that, based on the experience of loans originated between 1976 and 1980,
premiums of 2 to 22 basis points are adequate, given the predicted risk (p. 367).
Residential Mortgage Default: A Review of the Literature 367
The Proportional Hazard Estimation of Default Probabilities
Proportional hazard estimation is the state-of-the-art methodology in
default studies. Quigley and Van Order (1991) used a proportional
hazard model to estimate the probability of default.
45
The use of this
methodology is consistent with the continued application of innovative
statistical methods developed throughout the past three decades to study
default. Prior applications include the use of regression analysis (Page
1964; von Furstenberg 1969), multivariate discriminant analysis (Herzog
and Earley 1970), stepwise discriminant analysis (Morton 1975), cohort
analysis (von Furstenberg and Green 1974), tobit estimation (Webb
1982), logit estimation (Vandell and Thibodeau 1985), and multinomial
logit estimation (Zorn and Lea 1989; Cunningham and Capone 1990).
Hazard methodology is ideally suited to analyze default risks in loan
pools.
46
If we define hazard as a chance event (i.e., default) and hazard
rate as the probability that this event will occur in a particular period
given that it did not occur at the beginning of the period (i.e., the mortgage
is current at the beginning of the period), then a hazard model can be used
to estimate the probability of default in the first year, second year, and
so on. A hazard model can also be used to analyze the factors that affect the
hazard rate each year, for example, the equity in the home and the difference
between par and market value of the mortgage. By statistically estimating
hazard functions, we can measure the effects of these factors on the
occurrence of default.
47
In turn, the results of this statistical estimation
45
The proportional hazard model was first used in the loan termination literature to
analyze mortgage prepayment behavior. See, for example, Green and Shoven (1986) and
Quigley (1987). Other recent studies on residential default and delinquency that have used
proportional hazard methodology include Harmon (1989) (cited in Vandell et al. 1991) and
Van Order (1990). Vandell et al. (1991) used this methodology in their study of commercial
real estate default.
46
The presentation in this paragraph follows the general presentation of the hazard
models in Van Order (1990).
47
In technical terms, on the basis of proportional hazard methodology, the probability of
default (a), given the exogenous factors x
1
,..,x
n
at time t, can be divided into two
multiplicative factors:
Prob = (a) * (x
1
,..., x
n
),
where
(a) is the baseline hazard, which is the proportion of the population that would default
even under completely stationary or homogenous conditions. The baseline hazard gives
the normal time profile of conditional default rates (the probability of default in year 1,
year 2, etc., of a loan with a given loan-to-value ratio [Van Order 1990]); and
(x
1
,.,x
n
) are the exogenous factors that make default more or less likely.
The proportionality assumption refers to the fact that if the factors x
l
,..,x
n
make turnover
more likely at one age, they also have an equiproportional impact at all ages (Green and
368 Roberto G. Quercia and Michael A. Stegman
can be used in different types of analysis, such as mortgage pricing, or to
answer questions like this: How much greater is the chance of default for
a 95 percent loan-to-value loan versus a 75 percent loan-to-value loan?
Van Order 1990, p. 29).
Van Order (1990) presented an example of the use of this methodology to
estimate mortgage pricing.
48
He found that a loan with a loan-to-value
ratio of 80 percent or less originated in 1980 had about a 1.4 percent
chance of defaulting in the first ten years. Given that the loss on default
is about 25 cents on the dollar for an 80 percent loan-to-value-ratio loan,
an upfront charge of .25 1.4 percent, or .35 percent (an annual charge
of about 8 basis points) would cover the expected losses (p. 30).
49
As the
use of the proportional hazard methodology becomes widespread, other
aspects of the default experience may be better understood.
Recent Developments
The contribution of most third-generation studies is largely methodologi-
cal, both in terms of advancing better measures of mortgage risk and
using of sophisticated estimation techniques. Conceptually, the basic
premises postulated by second-generation studies have not been revised.
There is consensus among analysts about viewing default as an option in
which net equity has the dominant role. However, the issue of whether
or not this option is exercised ruthlesslythat is with no consideration
Shoven 1986, p. 45). The effect of these factors on default is also assumed to be time-
separable, that is, past and future attributes of the environment are assumed to have no
effect on turnover in the present (Green and Shoven 1986, p. 45). Assuming an exponen-
tial functional form (Green and Shoven 1986; Quigley 1987; Van Order 1990), the hazard
rate of default after t years (h[t]) can then be expressed as (Van Order 1990, p. 31)
h(t) = (t)e
bx
,
where
(t) is a series of dummy coefficients given the baseline hazard rate for each year after
origination;
e is the exponential function;
b are the coefficients to be estimated that measure the effect of x on the hazard function;
and
x are the explanatory, exogenous factors l...n.
48
For a comprehensive review of the option literature on mortgage pricing, pricing of both
prepayment and default risks, refer to Hendershott and Van Order (1987).
49
In his analysis, Van Order (1990) used data from about 725,000 single-family fixed-rate
conventional loans originated from 1976 through 1983 and purchased by Freddie Mac.
Residential Mortgage Default: A Review of the Literature 369
for transaction costs and crisis events that may delay, expedite, or
eliminate the need to exercise the default optionremains open to
debate.
The role of transaction and other costs in the default decision has been
the subject of several recent studies. For instance, Kau, Keenan, and Kim
(1991, p. 8) developed an intertemporal optimization model of the default
decision and contended that a borrower defaults not when the value of the
equity falls below the unpaid principal or the present value of payments,
but when it falls below the value of the mortgage to the lender (the cost
to the borrower). Consistent with Epperson et al. (1985), the authors
showed that this value includes both the value of exercising the option
now and the value of terminating the option in the future. Using
simulation analysis, the authors found support for their model. Specifi-
cally, they found that the value of the house must fall by substantially
more than the value of the mortgages termination option at the point of
zero equity before it is in fact rational for a borrower to default. The
authors concluded that the amounts involved can be mistaken for
transaction costs when in reality transaction costs play little or no role in
the default decision (p. 9).
50
Quigley and Van Order (1992) disagreed; they contended that transac-
tion costs, moving costs, reputation costs, and capital constraints make
the exercise of the default option on residential mortgages less ruthless
than in other frictionless financial markets (p. 2). In response to Kau,
Keenan, and Kim (1991), Quigley and Van Order (1992) acknowledged
that although the notion of a ruthless exercise of the default option is
consistent with observed default data, it does not explain three inconsis-
tencies: (1) peaks in average default rates over time for various initial
loan-to-value ratios are more similar than predicted by Kau, Keenan, and
Kim (1991); (2) loss severity increases significantly as a function of initial
loan-to-value ratio, contrary to theory; and (3) the spread between
default rates for high and low loan-to-value-ratio loans is less significant
than predicted by Kau, Keenan, and Kim (1991).
Quigley and Van Order (1992) found support for their contention in data
from Freddie Mac loans.
51
Although they acknowledged that transaction
50
In other words, Kau, Keenan, and Kim (1991) concluded that the default option is
exercised ruthlessly.
51
In their study of the efficiency of the single-family housing market and the role that
transaction costs (a market imperfection) have in this market, Quigley and Van Order
(1992) undertook two types of analysis. First, using data on the default experience by
Freddie Mac, the authors estimated several specifications for a proportional hazard model
of default, using different measures of home equity. Second, the authors estimated several
specifications of a model of mortgage loss severity due to default. In general, the findings
of these analyses with regard to the significance of loan-to-value ratio, equity, and age of
the mortgage are consistent with those of prior work (the authors included only these
financial variables in their analyses).
370 Roberto G. Quercia and Michael A. Stegman
costs by themselves do not explain the discrepancies either, they claimed
that transaction costs, especially reputation costs, coupled with a ran-
domrather than deterministic-mortgage term are indeed consistent
with the observed default behavior. The term of the mortgage becomes
random because borrowers move for random reasons and the holders of
non-assumable mortgages pay off at par, not market value, when they
move (p. 29).
52
The authors did not test this contention empirically.
In a recent study, Giliberto and Houston (1989) further examined the role
of crisis events and costs on default in their presentation of a theoretical
model of default that explicitly considered moving opportunities. The
authors contended that borrowers purchase homes and mortgages that
are optimal at the time of loan origination. These homes and mortgages,
however, become suboptimal over time because of life-cycle and economic
events. Life-cycle events include marriage, divorce, death, and change in
job or transfer of job location. Economic events that may make homes and
mortgages suboptimal include a decline in value or a loss of job or income
and an increase in housing costs, which make the mortgage payments
excessively burdensome.
When a home, mortgage, or both become suboptimal, borrowers are said
to consider relocation and the default option. Giliberto and Houston
(1989) contend that a range of book equity exists within which borrowers
who are about to relocate could default (but would not necessarily do
so).
53
Within this range, both the equity and the value of relocation
opportunities associated with moving interact to determine default.
54
Factors affecting relocation opportunities include the present value of
the incremental income effects associated with moving, the current value
of the mortgage to the borrower, the current principal balance of the
mortgage, the difference between the market value and the value of the
property to the owners, and the costs of refinancing and moving. Giliberto
and Houston did not test their model empirically.
52
A particularly important random move is one forced by exogenous reasons, for example, job
loss or divorce. Under these circumstances, the term of the mortgage may be short and the
value of keeping the option alive may be negligible (Quigley and Van Order 1992, pp. 2930).
53
Thus, both the presence of negative equity and the inability to meet mortgage payments
are considered necessary but not sufficient conditions for default.
54
Giliberto and Houston (1989) considered their model consistent with prior work.
Although there is widespread acceptance that default is primarily driven by equity, there
is also some indication in the literature that default conditions can be modified when
borrowers have to move (Hendershott 1985, cited in Giliberto and Houston 1989). For
instance, inability to meet mortgage payments is one reason people have to move. Giliberto
and Houston considered highly beneficial relocation opportunities as reasons that people
have to move.
Residential Mortgage Default: A Review of the Literature 371
The Delinquency Decision in the Default Process
Related to but distinct from the borrowers decision to default is the
decision to delay making one or more scheduled loan payments. Accord-
ing to the premises of the borrower payment model discussed earlier,
another mortgage payment choice borrowers have every payment period
is to become delinquent.
55
Yet compared with the widespread interest in
default, the number of studies on delinquency is rather limited.
56
There
are two main reasons for this lack of research. First, default is considered
more serious and costly than delinquency. Borrowers who default give up
the title to their homes for the value of the mortgage, whereas borrowers
who become delinquent have every intention of keeping the title to the
property and continuing mortgage payments at some future time. Delin-
quency appears to be less severe than default.
Second, the delinquency decision is difficult to model. From the borrowers
perspective, delinquency can be considered a cash flow problem: Borrow-
ers who experience a decline in income or an unexpected increase in
expenditures are forced to choose between mortgage delinquency and a
reduction of nonmortgage expenditures. Thus, delinquency cannot easily
be framed within the prevailing option-based approach.
57
Given these difficulties and the fact that default is considered the most
serious and costly termination of the mortgage contract, the emphasis on
default is easily understood.
However, delinquency is costly to both borrowers and lenders. For
borrowers, delinquency costs include penalty charges, a lower credit
rating, and emotional distress borrowers may associate with the decision
to delay mortgage payments. For lenders, slow loansthose loans that
are chronically delinquentmay be almost as troublesome and costly as
loans that reach foreclosure (Sandor and Sosin 1975). This fact alone
should warrant a more widespread interest in the study of delinquency.
In addition, not all aspects of mortgage risk can be addressed adequately
in the study of default. For instance, Webb (1982) contended that an
55
Actually, borrowers payment choices are not as clearly defined as the model suggests. In
practice, a loan is considered delinquent before default. When payments are first missed, it
is not possible to know whether the borrower has defaulted or is just delinquent, but it is
possible retrospectively to identify those delinquent loans that were later cured (mortgage
payment restarted) and those that ended up in default (foreclosure occurred).
56
Similarly, the number of studies on delinquency is small compared with the number of
studies on prepayment, which is the other mortgage payment choice borrowers have.
57
As an anonymous referee correctly pointed out, If we believe the models which underlie the
modern option theory of default, then the right model is some form of competing risks model
with time-varying covariates. At a minimum, the time varying covariates include the
difference between the present discounted value of the mortgage at coupon and at current
interest rates, and the current equity in the house. The competing risks are mortgage
termination through default and prepayment, which are clearly related.
372 Roberto G. Quercia and Michael A. Stegman
analysis of delinquency, not default, was needed to assess whether
different mortgage risks exist among different segments of the popula-
tion, because the determinants of default are related to property and loan
characteristics, and these have only a marginal relationship to borrower
characteristics.
Nonetheless, delinquency has received little attention, and most studies
are based on the assumption that delinquency is triggered by the same
factors as default. Delinquency has, however, been analyzed from both
the lender and the borrower perspectives.
The Lender Perspective
The earlier studies of delinquency attempted to identify the factors
known to lenders at the time of loan origination that were associated with
subsequent delinquent loans. Consistent with findings of the default
studies, three loan factors had a consistent and positive effect on delin-
quency: loan-to-value ratio, the presence of junior financing (Herzog and
Earley 1970; von Furstenberg and Green 1974), and the age of the
mortgage (von Furstenberg and Green 1974).
58
Similarly, two borrower-
related factors, borrower occupation and household income, had signifi-
cant effects on the decision to delay mortgage payment.
59
Because a
majority of delinquencies are cured, these early studies showed that
variables capturing home equity and a borrowers ability to pay are less
systematically related to delinquency than to default (von Furstenberg
and Green 1974; Morton 1975).
60
58
In their multivariate regression analysis, Herzog and Earley (1970) found initial loan-
to-value ratio to be significantly related to the delinquency decision. The presence of junior
financing was found to be the most important loan characteristic affecting this decision.
Loan purpose, such as construction, was also found to be a significant predictor of
delinquency. In contrast, the authors found term of loan to have no effect on delinquency.
In their analysis of 7,609 loans originated by one lender in Pittsburgh, Pennsylvania, von
Furstenberg and Green (1974) found that if the initial loan-to-value ratio is raised from
80 percent to 90 percent, delinquency rates will increase by over two-thirds, ceteris
paribus. The authors also found that delinquency rates peak four years after loan
origination and fall to about one-third of their initial level by year 15, thus exhibiting an
age pattern similar to that of default rates.
59
In their analysis of borrower characteristics, Herzog and Earley (1970) found borrowers
occupation, a proxy measure for the stability of income, to be highly significant. In
contrast, mortgage-payment-to-income ratio at the time of origination was found not to be
significant. In their analysis, von Furstenberg and Green (1974) found income to be
significant and negatively related to delinquency. An increase in income from $5,000 to
$10,000 lowered the expected delinquency rate by 31 percent (p. 1547).
60
For instance, in comparing default with delinquency, von Furstenberg and Green (1974)
found that the delinquency elasticities with respect to home equity and family income were
only half as large in absolute value as the corresponding default elasticities. In his
discriminant analysis of loans originated from 24 financial institutions in Connecticut,
Morton (1975) arrived at similar conclusions. In addition, he found that borrowers with
five or more dependents and those living in properties with three or more units were more
likely to be delinquent in their payments than were other borrowers.
Residential Mortgage Default: A Review of the Literature 373
The Borrower Perspective
In contrast to the early works, later studies analyzed the delinquency
decision from the borrower perspective. The decision to delay mortgage
payment may be made when borrowers are faced with a decline in
income and are forced to choose between mortgage delinquency and a
reduction of nonmortgage expenditures. In his study of potential delin-
quency under alternative mortgage instruments (AMIs), Webb (1982)
examined such a premise with data from the Panel Study of Income
Dynamics (Survey Research Center, University of Michigan).
Defining potential delinquency as increases in mortgage payment-to-
income ratio over time (housing burden), Webb (1982) found that borrower
characteristics play a role in explaining simulated potential delinquencies.
Households headed by older persons, minorities, or persons in occupations
with high income variability were more likely to experience increases in
housing burden. In turn, mortgages with a high degree of variability in
payments and with a relatively slow rate of payment growth, such as ARMs,
or with a steady but slow rate of growth, such GRMs, were less risky than
mortgages with payments that increase steadily but at a relatively high rate
of growth, such as PLAMs. In assessing the relative contribution of income
and mortgage payment variability to potential delinquency, Webb found
that high-risk borrowers were consistently more likely to be delinquent
than were other borrowers, regardless of the degree of variability in
mortgage payments. The severity and duration of potential delinquency
were also related to borrower characteristics. However, AMIs with the most
variability in payments exhibit the highest risk of delinquency, regardless
of borrower characteristics.
Although empirically substantive, early studies of delinquency lack a
formal theoretical treatment. In their study of the default decision,
Vandell and Thibodeau (1985) also considered the delinquency option in
their two-period maximization model of consumer choice.
61
However,
61
Vandell and Thibodeau (1985, pp. 295296) expressed the payoff function if borrowers
choose to become delinquent as
W
Del
= (Y R)(1 + r
i
+(V
T
L
T
) + W(1 + r
i
) Q(1 + r
d
)
where
W
Del
= payoff function if borrower chooses to become delinquent;
Y = real annual after-tax household income;
R = required real nondiscretionary expenditures (other than housing);
r
i

=
expected real return on nonhousing investments;
V
T
= expected real market value of the property;
L
T
= expected real outstanding loan balance on mortgage;
W = current real nonhousing wealth;
374 Roberto G. Quercia and Michael A. Stegman
their empirical analysis examined the default option exclusively; they did
not test the delinquency decision. In a recent study, Harmon (1989) used
proportional hazard methodology to examine the delinquency decision.
62
62
Compared with the thoroughness of default studies, little is known about
the delinquency decision. Recent developments in the default literature
suggest that crisis events (e.g., Vandell and Thibodeau 1985) and the
desire or need to move (e.g., Foster and Van Order 1984; Giliberto and
Houston 1989) may play an important role in the borrowers decision to
default. Given that these events are only marginally related to loan
characteristics and fully related to borrower characteristics, an analysis
of the default decision within a framework that incorporates the delin-
quency decision may be more appropriate. Ultimately, a better under-
standing of the delinquency decision may lead to a reassessment of the
borrower payment model and its analytical assumption that delinquency
and default decisions are distinct and may suggest instead that these
decisions are sequential and related.
63
Residential Mortgage Default: What is Known and What is
Unknown
The review of the literature presented here indicates a continued
interest in the subject of mortgage default. Today, most studies view
default from the option perspective, in which a borrowers home equity
has the dominant effect. There is also some evidence of the importance
of transaction costs and borrower expectations in affecting the exercise
of the default option. In contrast, the role of other borrower-related
factors in the default decision is not so well understood. For instance,
household income and mortgage payment have been found both to have
an effect and to have no effect on default. A major reason for these mixed
Q = required real after-tax payment on mortgage (plus taxes and insurance and other
ownership costs); and
r
d
= expected real cost of delinquent payment, including interest and penalties.
62
Cited in Vandell et al. (1991).
63
To our knowledge, only one study has ever examined this contention. In their study of
mortgage delinquency and foreclosure, Herzog and Earley (1970) estimated the determi-
nants of conditional foreclosure risk, that is, the risk that loans already delinquent will be
foreclosed. The authors found that significant effects on conditional foreclosure risk were
similar to those affecting delinquency, with three exceptions. First, term of the loan was
found to be negatively related to delinquency but directly related to conditional risk.
Second, while borrower occupation at time of loan origination was found to have a
significant effect on delinquency, it was found to have no consistent and significant effect
on conditional risk. Finally, while only loans made for refinancing purposes exhibited a
higher risk of delinquency, loans made for both refinancing and new construction had a
high conditional risk.
Residential Mortgage Default: A Review of the Literature 375
findings has been a lack of adequate panel data with relevant borrower,
property, and loan information over time. This problem could be solved
by the construction and maintenance of a widely accessible longitudinal
database of borrowers who are representative of U.S. home buyers.
What is Known: the Role of Loan Characteristics
Consistently, home equity, or the related measure of loan-to-value ratio,
has been found to influence the default decision. There is a consensus in
most recent default studies that the correct measure of a borrowers net
equity is the contemporaneous market value of property less the contem-
poraneous market value of the loan, a measure that also incorporates
borrower expectations. Default probabilities estimated using this mea-
sure indicate the importance of equity in the default decision. However,
they also indicate the importance of transaction costs and the complexity
of estimating the value of the default option, because there is value in
keeping the default option viable. For instance, simulations indicate
that the probability of default in the presence of a 10 percent negative
equity in year 5 after origination is only 1.75 percent (Vandell and
Thibodeau 1985).
What is Unknown: the Role of Transaction Costs and Borrower-
Related Factors
The role of transaction costs and borrower-related factors in the default
decision is less well understood. The debate over the importance of
transaction costs on the exercise of the default option, exemplified by the
works of Kau, Keenan, and Kim (1991) and Quigley and Van Order
(1992), remains unresolved. Kau, Keenan, and Kim (1991) have solved
numerically an option-based theoretical model of default that indicates
that transaction costs play little or no role in the exercise of the option;
therefore, they conclude that the option is exercised ruthlessly. Quigley
and Van Order (1992), however, have identified a number of inconsisten-
cies between the theoretical premises of the ruthless model and observed
default behavior. Quigley and Van Order suggest that reputation costs
(one form of transaction cost), along with a random term of the mortgage,
can explain observed default behavior, especially among borrowers with
nonassumable mortgages who want or have to move. This premise,
however, remains to be tested empirically.
Similarly, the role that borrower-related factors have in the default
decision needs to be addressed in future research. The lack of consistent
findings in this area is most likely due to the fact that all borrower
information at the time of default is estimated from ex-ante information,
376 Roberto G. Quercia and Michael A. Stegnan
using national, regional, or local indices that may not reflect events or
changes in the individual circumstances of borrowers who default.
When new panel data with the necessary borrower, loan, and property
information become available, a more comprehensive analysis of the
effects of borrower factors on default will be possible.
A better understanding of the role of borrower-related factors in default
is of crucial importance for practical and theoretical reasons. For
practical reasons, a better understanding can be used, for instance, to
extend homeownership opportunities to borrowers now considered risky.
If the effects of factors such as self-employment on default are proxies for
income variability, then it should be possible to minimize mortgage risk
by designing AMIs to address them. If, conversely, these effects are a
reflection of lower permanent incomes among some borrowers, then
default risks cannot be minimized through the use of AMIs (Vandell and
Thibodeau 1985). Lenders and loan-insuring institutions could also use
this information to set mortgage interest rate premiums and to price
mortgages more in line with the real risk represented by borrowers with
certain characteristics.
Understanding borrower-related effects is also important for theoretical
reasons. The notion that the desire or need to move may lead to the
decision to default has long been recognized (von Furstenberg 1969; von
Furstenberg and Green 1974; Giliberto and Houston 1989; Price
Waterhouse 1990) but has never been tested empirically. Ex-post infor-
mation is needed to analyze whether borrower factors such as crisis
events are indeed driving forces underlying the default decision and to
analyze how the decision to move relates to the equity position. The
notion suggests a possible bridge between the mobility and default
decision (Giliberto and Houston 1989).
The need to understand the effect of borrower-related factors also
suggests another area of further research. A weakness in the default
literature reviewed is the lack of analysis of the default experience of
borrowers holding AMIs such as ARMS. Only two studies, those of Zorn
and Lea (1989) and Cunningham and Capone (1990), have examined
ARM default rates, and both studies have limited applicability. As an
anonymous reviewer stressed, Not only is more work needed on default
experience with these instruments, but it may reveal stronger relation-
ships between borrower characteristics and mortgage default than the
fixed-rate mortgage experience.
In conclusion, the current state of the literature indicates that default
depends clearly on loan characteristics, mainly home equity. Less cer-
tain, however, is the role that transaction costs and borrower-related
factors play in the default decision. While the analysis of the default
Residential Mortgage Default: A Review of the Literature 377
decision of borrowers holding nonassumable mortgages may clarify the
importance of transaction costs, the development of an expanded default
model, which includes considerations commonly associated with delin-
quency, may clarify the role of borrower-related factors. Similarly, the
development of an expanded model needs to incorporate the mobility
decision.
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