Optimal Put Exercise: An Empirical Examination of Conditions for Mortgage Foreclosure

Abstract

Implicit in option-pricing models of mortgage valuation are threshold levels of put-option value that must be crossed to induce borrower default. There has been little research into what these threshold values are that come out of pricing models, or how they compare to exercised option values seen in empirical data. This study decomposes boundary conditions for optimal default exercise to look at the economic dynamics that should lead to optimal default timing. Empirical data on FHA insured mortgage foreclosures is then examined to discern the predictive influence of optimal-option-valuation-and-exercise variables on observed default timing and values. Interesting results include a new understanding of how to measure and use property equity variables during economic downturns, house price index ranges over which default is exercised for various classes of borrowers, and implied differences in appreciation rates between market price indices and foreclosed properties.

Keywords: mortgage default, loss severity, foreclosure