DEFAULT PROBABILITIES FOR MORTGAGES

Models now exist for valuing the default option embedded in a mortgage . Implicitly, these models generate all the information necessary to d etermine the probability of default, in any possible situation. Econom ists and policymakers may find such default probabilities considerably more interesting than the nonobservable dollar value of the default o ption. This paper provides the analytical procedure necessary to calcu late such probabilities and presents a wide range of results. The deci sion to terminate a mortgage results in the loss of the options to def ault or prepay in the future. Because of this consideration, the price of a house must fall below the point of zero equity before a rational borrower defaults. We provide evidence that even in the absence of tr ansaction costs this value of delay results in substantial levels of n egative equity being observed without default occurring. In fact, by n ot accounting for the value of delay, most of the current empirical li terature cited in this article substantially overestimates the role of transaction costs in the decision to default. (C) 1994 Academic Press , inc.