The Role of Insurance in Debt Renegotiation: Evidence from Mortgage Market

Abstract

This paper studies the effects of debt insurance on the likelihood of debt renegotiation with the setting of mortgages. Mortgage insurance enables mortgage holders to potentially get compensation for the loss in mortgage investment resulting from borrower’s default and subsequent liquidation. If a mortgage loan becomes delinquent, the borrower may apply for mortgage modification. According to moral hazard theory, mortgage holders are less likely to accept mortgage modification if mortgages are guaranteed by mortgage insurance, because their loss can be paid by the insurance company. We empirically test this effect using datasets including detailed information of mortgage origination and performance. We find that higher insurance coverage leads to lower likelihood of modification and the magnitude of this moral hazard effect is significant. This paper helps us better understand mortgage holders’ reluctance to modify mortgage loans, an important factor of the higher liquidation rate in the financial crisis.

Keywords: debt renegotiation, financial crisis, loan modification, mortgage, insurance, foreclosure, loss mitigation

JEL Classification: D1, D8, G1, G2