Three Essays on Mortgage Default
This dissertation consists of three essays on mortgage default. The first essay discusses the determinants of mortgage default. The financial crisis of 2007-2008 was precipitated by default in subprime mortgages. This episode spurred a lot of research on mortgage default. The essay surveys this research with a focus on what determines mortgage default. It emphasizes that the market value of home equity determines default, not the book value of equity.
The second essay discusses the valuation of mortgage backed securities in an equilibrium framework that explicitly incorporates default decisions of homeowners, along with essential contractual features of these securities. The analysis begins by valuing Collateralized Mortgage Obligations (CMOs), which are securities created by dividing a pool of mortgages into senior and residual tranches. A major finding is that bonds issued on the senior tranche can be risk free, low risk, or high risk in equilibrium, depending on the relative size of the tranche. For house price data from the Case-Shiller house price index between 2006 and 2011, model implied senior bond values decline by 10% and residual bond values decline by 60%. The essay also discusses the valuation of CMO-squared and Credit Default Swaps, which are both derivative securities created from CMOs.
The third essay discusses valuation of mortgages with coupon resets, when homeowners optimally exercise the option to default on their mortgage. The analysis shows that the optimal default boundary is discontinuous at the reset date when the coupon after the reset is large, compared to the coupon prior to the reset. The model connects equilibrium yield spreads on these mortgages to initial loan-to-value ratios, coupon structure, time remaining until the reset, expected growth rate in house prices, and the volatility of house prices. Conditional on the initial loan-to-value ratio, mortgages with low initial payments followed by high payments after the reset have higher default risk than the corresponding fixed rate mortgage. The essay also discusses the valuation of balloon payment mortgages.