Default Risk In The U.S. Mortgage Market
Source: University of Iowa
The authors analyse the default risk inherent in various house financing strategies, using a real options analysis. An empirical model is fit to US house price and interest rate data, and this is used to estimate the optimal exercise frontier for the default option in a mortgage, accounting for the other embedded option: the refinancing option. They find that the recently popular "Zero down", floating rate interest only mortgages can lead to situations where default is optimal even after quite small decline in house prices. They also find that the type of mortgage selected (Fixed Rate or Adjustable Rate) can lead to very different sensitivities to interest rates in the decision to default.