...borrowers individually or jointly make choices which lead to the following outcomes: (1) resumption of payments, (2) termination by prepayment, or (3) foreclosure. Our estimates of a logit model indicate that termination option values and local area economic and housing market conditions affect default resolution probabilities. Perhaps more importantly, simulations using the logit model indicate that the efficiency of the default resolution process may be substantially improved by legal and regulatory reforms.

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Homeownership has been associated with benefits to individuals, families and society; it is the cornerstone of the "American dream." The value that individuals place on their homes is indicated by the low default rates on residential mortgage loans. (1) Nonetheless, a small percentage of homeowners default on their mortgages and relinquish their homes to lenders by allowing foreclosure. Although small as a percentage of all mortgage originations, defaults (and subsequent foreclosures) are large in absolute numbers, producing substantial losses to lenders/investors and higher housing finance costs to consumers. This paper analyzes factors that affect the likelihood that defaults will ultimately foreclose and provides information on foreclosure probabilities that will allow lenders/investors and public policy analysts to implement strategies to improve the efficiency of default resolution and reduce costs to consumers.

The analysis of mortgage decisions starts from the assumption that mortgagors possess an implicit option to terminate loans and relinquish their homes by defaulting and allowing foreclosure. Unanticipated (denoted "trigger") events may induce default, but such events do not necessarily culminate in foreclosure since loans may also be terminated by prepayment. However, exercising the prepayment option in the face of financial distress presupposes a positive equity position and a relatively liquid housing asset. Most theoretical and empirical research analyzes financially motivated or option-induced terminations, either by default or prepayment. While trigger events force households to breach financial commitments, in the option framework default is based on wealth maximization irrespective of trigger events. Default is predicted when equity is less than the present value of mortgage payments: The default option is "in the money." The implicit assumption of these models is that once initiated, borrowers do not rescind default option exercise. The strategy of so-called "ruthless" defaulters is to allow foreclosure and shift losses to lenders. Numerous researchers have used variations of option-based models to estimate either prepayment or default (or both) termination probabilities, and empirical results generally support the predictions of these models. (2)

A limitation of the option models is that defaults are defined as foreclosures. This assumption eliminates the consideration of an additional option for borrowers: the temporary suspension of payments (a short term "loan") to weather financial storms possibly caused by trigger events. Our estimates and mortgage market facts suggest that this option is important. (3) For example, only a minority (about 20% in recent years) of defaults result in foreclosure. Defaulted loans in which payments are resumed are "cured" while other defaults are terminated by prepayment prior to foreclosure. Determinants of resolutions cannot readily be evaluated in the standard option framework. Recent models developed by Ambrose and Capone (1996, 1998, 2000), Ambrose and Buttimer (2000) and Ambrose, Buttimer and Capone (1997) address this limitation by modeling default as a process in which borrowers and lenders reevaluate the decision to allow foreclosure. Current information on regional housing market conditions and lender default resolution initiatives may, for example, impact the decision to allow foreclosure. Ambrose and Capone (1998, 2000) analyze conditional foreclosure probabilities with a large sample of FHA loan defaults. Their results indicate that foreclosure probabilities depend on the costs of allowing foreclosure, which include default option values and housing market conditions.

Our research extends the analysis of conditional foreclosure probabilities in two ways. First, we analyze state specific laws and regulations that affect the costs and benefits of foreclosure on the default resolution decision. Also, we analyze a large national sample of conventional loans, which constitute the majority of mortgages issued and have different default characteristics relative to FHA mortgages. Our results indicate that foreclosure probabilities are, holding option values constant, sensitive to variables such as local economic conditions and state-specific statutes. The results indicate that legal and regulatory reforms would tend to increase the efficiency of the default resolution process, primarily by expediting foreclosure. (4) For example, our analysis indicates that a change to nonjudicial foreclosure, which reduces the time required to resolve defaults, could increase foreclosures by 25%. Further, the repeal of statutory redemption rights could increase foreclosures by 20%. While some of the potential gains to lenders from more efficient foreclosure procedures come at the expense of borrowers, there also is a reduction in dead-weight losses, for example, the costs associated with court calendar congestion and the costs of tying up funds during the extended default resolution timeframe.

Our results also provide information on the effect of age on foreclosure probabilities. Theoretical models and empirical results reported by Kau, Keenan and Kim (1993, 1994) indicate that foreclosures are most likely for recently originated loans. Our...

NOTE: All illustrations and photos have been removed from this article.



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