Mortgage default and bankruptcy theory and empirical evidence
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Mortgage Default and Bankruptcy: Theory and Empirical Evidence . Wenli Li, FRB Philadelphia Michelle J. White, UCSD and NBER. What we do: . Examine the interaction of homeowners’ decisions to default on their mortgages and file for bankruptcy. We test:

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Mortgage Default and Bankruptcy: Theory and Empirical Evidence

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Mortgage Default and Bankruptcy: Theory and Empirical Evidence

Wenli Li, FRB Philadelphia

Michelle J. White, UCSD and NBER


What we do:

  • Examine the interaction of homeowners’ decisions to default on their mortgages and file for bankruptcy.

  • We test:

    • Whether homeowners are more likely to default versus file for bankruptcy when they gain financially from either, and

    • Whether homeowners are more likely to default versus file for bankruptcy when they are liquidity-constrained.

  • We use new data that combines information on mortgage debt and other types of debt.

    • Previously, the literatures on mortgage default and bankruptcy were separate because of lack of combined data.


How are mortgage default and bankruptcy decisions related?

  • Bankruptcy helps homeowners avoid mortgage default/keep their homes by discharging unsecured debt.

  • Bankruptcy helps homeowners keep their homes by delaying foreclosure and allows homeowners to repay mortgage arrears over five years.

  • But bankruptcy helps homeowners with high income or high assets less, since they must use repay from future income and assets.

  • Default helps homeowners preserve access to credit card loans—some choose default/avoid bankruptcy.

  • Bankruptcy helps homeowners give up their homes by discharging deficiency judgments.


Homeowners’ predicted mortgage default and bankruptcy decisions


Notes:

  • Diagram is separately calculated for each homeowner.

  • As shown it assumes that bankruptcy reform is in effect (means test), mortgage debt is fixed, and unsecured debt is fixed and high.

  • Homeowners are predicted to default and file for bankruptcy only when it is in their financial interest.

    • D/B predicted when house value is low and income is low. (House value is low enough that the cost of renting < cost of owning.)

    • D/NB predicted when V is low and Y is high.

    • ND/B predicted when V is higher and Y is high. (Here the income boundary between B and NB shifts to the right because of homeowners’ gains from filing for bankruptcy.)

    • ND/NB applies when V and Y are both high and when V is very high and Y is low. (Best not to default because must repay unsec debt from sale proceeds of the house.)


Same, but some homeowners default due to liquidity constraints


Notes:

  • Now some additional homeowners default even when it is against their financial interest b/c V is high. They default because of liquidity constraints.


Data:

We merge three datasets:

  • LPS: large sample of mortgages with information from the mortgage application, plus monthly updates on payment and bankruptcy.

  • Equifax: sample of individuals with information about all types of debt, plus quarterly updates on payment, credit scores, debt-to-income ratio.

  • HMDA: use it to merge LPS and Equifax based on date/location/principal of mortgage.


Final dataset:

  • All mortgages originated 2004-2006.

  • They are followed quarterly until the mortgage is paid off or transferred, the homeowner defaults or files for bankruptcy, or at the end of 2009.

  • Currently, we include only prime, fixed rate mortgages.

  • Each quarter, we also have:

    • Amount owed and payment record for second mortgages, credit card debts, student loans, auto loans, and installment loans. (Half of each debt if homeowner married.)

    • Updated credit score and debt-to-income ratio.

    • Income at origination and homeowner’s age, sex, marital status.


Specification:

  • We estimate a multi-probit model explaining:

    • Default/no bankruptcy (aD/NB).

    • No default/bankruptcy (aND/B).

    • Relative to no default/no bankruptcy (aND/NB).

    • We drop simultaneous default/bankruptcy because it’s very rare (aD/B).

  • Main variables of interest are the predicted decision variables D/NB, ND/B, D/B.

  • Control variables, quarter and state dummies.

  • Errors clustered by mortgage.


Predicted signs:


Summary statistics (quarterly)


Results w/o liquidity constraint:(% change when prediction changes)


Add liquidity constraint:

  • Rerun the model with an additional dummy variable for homeowners who are liquidity-constrained—combined debt payments are more than 50% of income.

  • % of observations that are liquidity-constrained?

  • Everything else remains the same.


Results with liquidity constraint:


Conclusions:

  • Homeowners’ mortgage default and bankruptcy decisions respond strongly to financial benefit. are related.

  • The two decisions are related—homeowners are more likely to file for bankruptcy.

  • Liquidity constraints make homeowners more likely to do both.


Future work:

  • Examine subprime mortgages and adjustable rate mortgages.

  • Compare results when default and bankruptcy decisions are independent.


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