PLAM Default Risk

Abstract

This article combines cross-sectional time series data on real estate appreciation rates during the 1974 to 1989 period with an option-based model of mortgage default to simulate the default and loss characteristics of price level-adjusted mortgages (PLAMs) and standard fixed-payment mortgages (FPMs). The analysis finds significantly higher default risk for PLAMs than recognized by previous research. In particular, the expected loss of twenty- and thirty-year PLAMs with common initial loan-to-value (LTV) ratios is two to seven times higher than the expected loss of comparable FPMs and these PLAMs have much longer periods of high default risk than FPMs. Maturity must be reduced to fifteen years in order to bring PLAM default risk approximately in line with FPM default risk for most LTVs.