Default Risk on Home Mortgage Loans: A Test of Competing Hypotheses

Abstract

Studies dealing with risk of default on home mortgage loans implicitly incorporate two alternative theories of default in the interpretations and explanations of empirical results. This paper provides a formalization of these competing theories and derives some testable hypotheses that may be used to distinguish between these theories empirically. Data obtained from the FHA file of individual loans insured under the Section 203(b) program are used to test these hypotheses. The evidence supports an equity maximization model of default in lieu of an ability-to-pay model. Implications of this finding for the design of an efficient homeownership subsidization program are explored briefly. Two major competing views of the causal process involved in the default decisions of mortgagors can be discerned from the published literature on the home mortgage loan default risk and from a variety of government reports and actuarial studies on the subject'. The first of these views, referred to here as the equity theory of default, holds that borrowers base their default decisions on a rational comparison of the financial costs and returns involved in continuing (or discontinuing) the periodic payments on the mortgage loan obligation. That is, they maximize the financial gain or minimize the financial loss that results from this decision. This view implies a strict optimizing behavior of mortgage borrowers. The second view, called here the ability-to-pay theory of default, maintains that mortgagors, in general, will refrain from defaulting on a loan as long as their income flow remains sufficient to meet the periodic payment without Jerry R. Jackson holds the Ph.D. degree. He is Chief, Applied Research Division, Engineering Experiment Station, Georgia Institute of Technology. He has served as Economist for the Federal Reserve Bank of Chicago and Oak Ridge National Laboratory. He also was a Senior Research Associate, Charles River Associates. David L. Kaserman, Ph.D. is Assistant Professor at the University of Tennessee. He has served as Economist for the U.S. Department of Housing and Urban Development, the Federal Trade Commission and the Oak Ridge National Laboratory. With the usual caveat regarding responsibility for possible remaining errors, the authors thank Roger Blair, Robert Buckley, Jerome Milliman, and Robert Trost for helpful comments on a previous draft of the paper. ' The literature concerned with this topic includes Gau [3, pp. 687-706], Herzog and Earley [5], Knight [7, pp. 13-20 and 8, pp. 1013], Morton [9, pp. 73-90], Sandor and Sosin [ 10, pp. 27-38], von Furstenberg [13, pp. 459-477; 14, pp. 229-242; 15, pp. 303-322; 16, 437-455], von Furstenberg and Green [17, pp. 5-19, and 18], and Williams et al. [19, pp. 101-1121. In addition, the Actuarial Division of FHA has published a variety of reports on the subject.