Residential Loan Renegotiation: Theory and Evidence

Abstract

If loan renegotiations are not uncommon, this alternative should be modeled into the contingent claims framework of mortgage pricing. There is no direct evidence on the frequency of loan renegotiation, however. A simple model of default indicates that renegotiation should occur more frequently in conventional loans versus FHA loans and in states with higher foreclosure costs versus those with lower costs. Since empirical tests using delinquency and foreclosure placement rates demonstrate no such behavioral difference, we conclude loan renegotiation does not occur frequently enough to warrant its consideration in mortgage pricing models. The rarity of circumstances under which renegotiation is mutually beneficial may account for this finding.