Residential Mortgage Default and Consumer Bankruptcy: Theory

Mortgage Default and Bankruptcy:
Theory and Empirical Evidence
Wenli Li, FRB Philadelphia
Michelle J. White, UCSD and NBER
What we do:
• Examine the interaction of homeowners’ decisions to
default on their mortgages and file for bankruptcy.
• We test:
– Whether homeowners are more likely to default versus file
for bankruptcy when they gain financially from either, and
– Whether homeowners are more likely to default versus file
for bankruptcy when they are liquidity-constrained.
• We use new data that combines information on
mortgage debt and other types of debt.
– Previously, the literatures on mortgage default and
bankruptcy were separate because of lack of combined
How are mortgage default and
bankruptcy decisions related?
• Bankruptcy helps homeowners avoid mortgage
default/keep their homes by discharging unsecured debt.
• Bankruptcy helps homeowners keep their homes by
delaying foreclosure and allows homeowners to repay
mortgage arrears over five years.
• But bankruptcy helps homeowners with high income or
high assets less, since they must use repay from future
income and assets.
• Default helps homeowners preserve access to credit card
loans—some choose default/avoid bankruptcy.
• Bankruptcy helps homeowners give up their homes by
discharging deficiency judgments.
Homeowners’ predicted mortgage default
and bankruptcy decisions
• Diagram is separately calculated for each homeowner.
• As shown it assumes that bankruptcy reform is in effect (means
test), mortgage debt is fixed, and unsecured debt is fixed and high.
• Homeowners are predicted to default and file for bankruptcy only
when it is in their financial interest.
– D/B predicted when house value is low and income is low. (House
value is low enough that the cost of renting < cost of owning.)
– D/NB predicted when V is low and Y is high.
– ND/B predicted when V is higher and Y is high. (Here the income
boundary between B and NB shifts to the right because of
homeowners’ gains from filing for bankruptcy.)
– ND/NB applies when V and Y are both high and when V is very high
and Y is low. (Best not to default because must repay unsec debt from
sale proceeds of the house.)
Same, but some homeowners default due to
liquidity constraints
Figure 3. Predicted Probability to Default and File for Bankruptcy
income (thousands)
See the text for the value of the other variables we set for the hypothetic household
• Now some additional homeowners default
even when it is against their financial interest
b/c V is high. They default because of liquidity
We merge three datasets:
LPS: large sample of mortgages with
information from the mortgage application, plus
monthly updates on payment and bankruptcy.
– Equifax: sample of individuals with information
about all types of debt, plus quarterly updates on
payment, credit scores, debt-to-income ratio.
– HMDA: use it to merge LPS and Equifax based
on date/location/principal of mortgage.
Final dataset:
• All mortgages originated 2004-2006.
• They are followed quarterly until the mortgage is paid off
or transferred, the homeowner defaults or files for
bankruptcy, or at the end of 2009.
• Currently, we include only prime, fixed rate mortgages.
• Each quarter, we also have:
– Amount owed and payment record for second mortgages, credit
card debts, student loans, auto loans, and installment loans.
(Half of each debt if homeowner married.)
– Updated credit score and debt-to-income ratio.
– Income at origination and homeowner’s age, sex, marital status.
• We estimate a multi-probit model explaining:
Default/no bankruptcy (aD/NB).
No default/bankruptcy (aND/B).
Relative to no default/no bankruptcy (aND/NB).
We drop simultaneous default/bankruptcy because
it’s very rare (aD/B).
• Main variables of interest are the predicted
decision variables D/NB, ND/B, D/B.
• Control variables, quarter and state dummies.
• Errors clustered by mortgage.
Predicted signs:
D/NB actual
ND/B actual
D/NB predicted
Own effect (+)
Cross effect (-)
ND/B predicted
Cross effect (-)
Own effect (+)
Sequence effect
Sequence effect
D/B predicted
Summary statistics (quarterly)
Results w/o liquidity constraint:
(% change when prediction changes)
D/NB actual ND/B actual
D/NB predicted
ND/B predicted
D/B predicted
(own effect)
(cross effect)
(sequence eff.)
(cross effect)
(own effect)
(sequence eff.)
Add liquidity constraint:
• Rerun the model with an additional dummy
variable for homeowners who are liquidityconstrained—combined debt payments are
more than 50% of income.
• % of observations that are liquidityconstrained?
• Everything else remains the same.
Results with liquidity constraint:
D/NB actual ND/B actual
D/NB predicted
ND/B predicted
D/B predicted
(own effect)
(cross effect)
(sequence eff.)
(cross effect)
(own effect)
(sequence eff.)
• Homeowners’ mortgage default and
bankruptcy decisions respond strongly to
financial benefit. are related.
• The two decisions are related—homeowners
are more likely to file for bankruptcy.
• Liquidity constraints make homeowners
more likely to do both.
Future work:
• Examine subprime mortgages and adjustable
rate mortgages.
• Compare results when default and bankruptcy
decisions are independent.

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