Working Paper: NBER ID: w17516
Authors: John Y. Campbell; Joo F. Cocco
Abstract: This paper solves a dynamic model of a household's decision to default on its mortgage, taking into account labor income, house price, inflation, and interest rate risk. Mortgage default is triggered by negative home equity, which results from declining house prices in a low inflation environment with large mortgage balances outstanding. Not all households with negative home equity default, however. The level of negative home equity that triggers default depends on the extent to which households are borrowing constrained. High loan-to-value ratios at mortgage origination increase the probability of negative home equity. High loan-to-income ratios also increase the probability of default by tightening borrowing constraints. Comparing mortgage types, adjustable-rate mortgage defaults occur when nominal interest rates increase and are substantially affected by idiosyncratic shocks to labor income. Fixed-rate mortgages default when interest rates and inflation are low, and create a higher probability of a default wave with a large number of defaults. Interest-only mortgages trade off an increased probability of negative home equity against a relaxation of borrowing constraints, but overall have the highest probability of a default wave.
Keywords: mortgage default; loan-to-value ratio; loan-to-income ratio; financial crisis
JEL Codes: E21; G21; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| negative home equity (G51) | mortgage default (G33) |
| declining house prices + large mortgage balances (G21) | negative home equity (G51) |
| higher LTV ratios at mortgage origination (G21) | negative home equity (G51) |
| higher LTV ratios at mortgage origination (G21) | probability of default (G33) |
| high LTI ratios (G32) | borrowing constraints (F34) |
| high LTI ratios (G32) | probability of default (G33) |
| ARMs (G21) | mortgage default in high-interest rate environments (G21) |
| FRMs (G21) | mortgage default when inflation and interest rates are low (G21) |
| interest-only mortgages (G21) | probability of default (G33) |
| LTV and LTI ratios (G32) | mortgage default (G33) |