Default Probabilities for Mortgages

• Published in: Journal of urban economics 1994-05, Vol.35 (3), p.278-296
• Main Authors: Kau, James B., Keenan, Donald C., Kim, Taewon
• Format: Article
• Language: English
• ISSN: 0094-1190; 1095-9068
• DOI: 10.1006/juec.1994.1017

Models now exist for valuing the default option embedded in a mortgage. Implicitly, these models generate all the information necessary to determine the probability of default, in any possible situation. Economists and policymakers may find such default probabilities considerably more interesting than the nonobservable dollar value of the default option. This paper provides the analytical procedure necessary to calculate such probabilities and presents a wide range of results. The decision to terminate a mortgage results in the loss of the options to default or prepay in the future. Because of this consideration, the price of a house must fall below the point of zero equity before a rational borrower defaults. We provide evidence that even in the absence of transaction costs this value of delay results in substantial levels of negative equity being observed without default occurring. In fact, by not accounting for the value of delay, most of the current empirical literature cited in this article substantially overestimates the role of transaction costs in the decision to default.