Academic journal article Real Estate Economics

Equity Dilution: An Alternative Perspective on Mortgage Default

Academic journal article Real Estate Economics

Equity Dilution: An Alternative Perspective on Mortgage Default

Article excerpt

Empirical research on mortgage default in the single-family market has focused on the value of the borrower's put option using house price indices to estimate contemporaneous loan-to-value ratio or the probability of negative equity. But since the borrower possesses the option to increase leverage by taking on additional debt secured by junior liens subsequent to loan origination (a phenomenon termed here equity dilution), even a perfect house price adjustment cannot be expected to accurately measure changes in borrower equity over time. Since junior liens are generally unobservable to senior debt holders, proxies are required in empirical applications. This paper employs an independent estimate of junior lien probability developed from the 1998 Survey of Consumer Finances combined with loan level mortgage performance data to examine the role junior liens play in increasing default risk.


Fostering home ownership has long been an important public policy objective in the United States, yet the majority of home purchases require use of mortgage debt and not all mortgages are repaid as contracted. Indeed, Elmer and Seelig (1999b) document a long-term secular trend of increasing rates of default. Delinquency and foreclosure rates are currently high, notwithstanding robust housing conditions. (1) Likewise, personal bankruptcies continue to reach all-time highs. (2) Accordingly, lenders, researchers, policy analysts and governmental officials continue to seek to better understand mortgage default. Figure 1 depicts the paradoxical pattern of increasing house prices together with increasing rates of mortgage default. Since 1986, house prices in the United States have approximately doubled, while foreclosure rates on government-insured loans have tripled and foreclosure rates on conventional loans have increased by 50%.


Researchers have recognized that contingent claims methodologies can provide important insights into the mortgage market. Under this view, a mortgage loan may be treated as a fixed income instrument combined with American put and call options held by the borrower and written by the lender. The right to prepay the mortgage at any time is a call option at par; the ability to default on the mortgage at any time is a put option in which the mortgage is "sold" to the lender for the market value of the property. (3) Despite the focus on option-based models, an important option possessed by mortgagors has been overlooked: the option to add mortgage debt secured by junior liens subsequent to loan origination. As a general rule, except in the case of some commercial loans, acceleration provisions of mortgage notes are not triggered by further encumbrance of the collateral property; hence, an implicit option to further encumber is available to the borrower.

How do junior liens affect the risk borne by the senior mortgage holder? This is a complex question. On the one hand, a reduction in borrower equity and an increase in debt service requirements would seem likely to increase default probability on the first mortgage. But since junior liens are by definition subordinate, there would seem to be no effect on loss severity and hence credit losses. On the other hand, if debt service requirements on the junior lien consume funds that would have otherwise gone to maintenance, the condition (and hence the value) of the collateral may be impaired, producing an increase in loss severity upon default. (4) Alternatively, if funds from junior lien borrowing are used to improve the condition and thereby increase the value of the property, then, if the incremental value is sufficient to offset the incremental debt, the combined loan-to-value ratio (LTV; including both senior and subordinate financing) could remain constant or actually decline.

It is worth noting that in segments of the mortgage market in which default is more frequent and its consequences more severe, namely, commercial property, subordinate financing is often expressly prohibited. …

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