Insolvency, Trigger Events, and Consumer Risk Posture
in the Theory of Single-Family Mortgage Default*
Peter J. Elmer
Senior Economist
Phone: 202-898-7366
Fax: 202-898-7222
e-mail: pelmer@fdic.gov
Steven A. Seelig
Deputy Director
Phone: 202-898-8602
Fax: 202-898-7222
e-mail: sseelig@fdic.gov
FDIC Working Paper 98-3
Abstract
This paper integrates notions of insolvency, trigger events, and consumer risk
posture into the theory of single-family mortgage default. It presents a traditional
consumer- or choice-theoretic framework that recognizes common elements of mortgage
optionality alongside insolvency, income, house price, and interest rate variables. Two
motivations for mortgage default, insolvency and exercise of a strategic option, are
identified and compared under alternative settings. The model suggests that insolvency is
a primary motivation for default. Broader measures of consumer financial health appear
to provide better measures of the likelihood of default than do narrow measures based
solely on home or mortgage value. Adverse shocks to income and house prices, but not
interest rates, also affect default and insolvency through the erosion of personal wealth.
Empirical evidence supporting the hypotheses developed is provided along with an
analysis of the aggregate time series of mortgage default.
*The authors would like to thank David Ling for helpful comments. The views expressed
are those of the authors and not necessarily those of the Federal Deposit Insurance
Corporation.
in the Theory of Single-Family Mortgage Default*
Peter J. Elmer
Senior Economist
Phone: 202-898-7366
Fax: 202-898-7222
e-mail: pelmer@fdic.gov
Steven A. Seelig
Deputy Director
Phone: 202-898-8602
Fax: 202-898-7222
e-mail: sseelig@fdic.gov
FDIC Working Paper 98-3
Abstract
This paper integrates notions of insolvency, trigger events, and consumer risk
posture into the theory of single-family mortgage default. It presents a traditional
consumer- or choice-theoretic framework that recognizes common elements of mortgage
optionality alongside insolvency, income, house price, and interest rate variables. Two
motivations for mortgage default, insolvency and exercise of a strategic option, are
identified and compared under alternative settings. The model suggests that insolvency is
a primary motivation for default. Broader measures of consumer financial health appear
to provide better measures of the likelihood of default than do narrow measures based
solely on home or mortgage value. Adverse shocks to income and house prices, but not
interest rates, also affect default and insolvency through the erosion of personal wealth.
Empirical evidence supporting the hypotheses developed is provided along with an
analysis of the aggregate time series of mortgage default.
*The authors would like to thank David Ling for helpful comments. The views expressed
are those of the authors and not necessarily those of the Federal Deposit Insurance
Corporation.
I. Introduction
During the past decade it has become commonplace to view single-family mortgage
default as a put option, whereby homeowners demand that lenders purchase their homes in
exchange for mortgage elimination.1 The great advantage of this approach is that it emphasizes
optionality embedded in home mortgages in a relatively simple two-state framework of house
prices and interest rates, both of which can be observed and tested.2
Despite the appeal of two-state option models, empirical specifications of mortgage
default are increasingly divorced from those implied by option theory. While all tests confirm a
central role for home equity, the evidence has not consistently supported the expected role of
other variables implied by the theory, such as interest rates.3 Empirical work otherwise
persistently supports a significant role for a variety of variables that are difficult to reconcile with
the two-state paradigm. For example, recent tests include unemployment, income, income
growth, and dummy variables for specific states.4 The two-state theme is also difficult to
reconcile with many mortgage market characteristics, such as the use of payment- and/or debt-to-
income ratios in standard underwriting, use of borrower credit scores in automated underwriting,
and the recent rise in origination of mortgages with LTVs as high as 125 percent.5 Indeed, these
perspectives generally point to a need to consider the roles of income shocks, debt, credit, and
other aspects of personal solvency in the default story.
Vandell (1995) follows this theme by stressing the need for a better “micro-level
understanding” of the roles of “trigger” events (such as unemployment) and solvency in
mortgage default. What is the role of insolvency in a micro-economic framework that recognizes
elements of mortgage optionality? Can the notion of trigger events be formally defined and
incorporated in such a framework? Specifications along these lines may improve our
1
During the past decade it has become commonplace to view single-family mortgage
default as a put option, whereby homeowners demand that lenders purchase their homes in
exchange for mortgage elimination.1 The great advantage of this approach is that it emphasizes
optionality embedded in home mortgages in a relatively simple two-state framework of house
prices and interest rates, both of which can be observed and tested.2
Despite the appeal of two-state option models, empirical specifications of mortgage
default are increasingly divorced from those implied by option theory. While all tests confirm a
central role for home equity, the evidence has not consistently supported the expected role of
other variables implied by the theory, such as interest rates.3 Empirical work otherwise
persistently supports a significant role for a variety of variables that are difficult to reconcile with
the two-state paradigm. For example, recent tests include unemployment, income, income
growth, and dummy variables for specific states.4 The two-state theme is also difficult to
reconcile with many mortgage market characteristics, such as the use of payment- and/or debt-to-
income ratios in standard underwriting, use of borrower credit scores in automated underwriting,
and the recent rise in origination of mortgages with LTVs as high as 125 percent.5 Indeed, these
perspectives generally point to a need to consider the roles of income shocks, debt, credit, and
other aspects of personal solvency in the default story.
Vandell (1995) follows this theme by stressing the need for a better “micro-level
understanding” of the roles of “trigger” events (such as unemployment) and solvency in
mortgage default. What is the role of insolvency in a micro-economic framework that recognizes
elements of mortgage optionality? Can the notion of trigger events be formally defined and
incorporated in such a framework? Specifications along these lines may improve our
1