Thursday, December 16, 2010

Strategic Default on First and Second Lien Mortgages During the Financial Crisis

By Julapa Jagtiani and William W. Lang (Philadelphia Fed)

Abstract: Strategic default behavior suggests that the default process is not only a matter of inability to pay. Economic costs and benefits affect the incidence and timing of defaults. As with prior research, the authors find that people default strategically as their home value falls below the mortgage value (exercise the put option to default on their first mortgage). While some of these homeowners default on both first mortgages and second lien home equity lines, a large portion of the delinquent borrowers have kept their second lien current during the recent financial crisis. These second liens, which are current but stand behind a seriously delinquent first mortgage, are subject to a high risk of default. On the other hand, relatively few borrowers default on their second liens while remaining current on their first. This paper explores the strategic factors that may affect borrower decisions to default on first vs. second lien mortgages. The authors find that borrowers are more likely to remain current on their second lien if it is a home equity line of credit (HELOC) as compared to a closed-end home equity loan. Moreover, the size of the unused line of credit is an important factor. Interestingly, they find evidence that the various mortgage loss mitigation programs also play a role in providing incentives for homeowners to default on their first mortgages.

Download here: www.philadelphiafed.org/research-and-data/publications/working-papers/2011/wp11-3.pdf

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