Strategic Default Research Articles

Should I default on my mortgage even if I can pay? Experimental evidence

We study strategic default in the laboratory, i.e., in a controlled experiment. Subjects are initially endowed with a house and a mortgage (we use neutral wording in the experiment), and must decide at each period in which their mortgage is alive among three options: making the mortgage payment, selling the house, or walking away from their house and defaulting on their mortgage. At each point in time, we can observe whether defaulters can afford to make the mortgage payment, and thus, directly compute the number of strategic defaulters. Subjects default in the right periods and quite fast learn what they should consume. We find experimental support for the “double trigger” hypothesis: individuals faced with low income and low house prices are more likely to default. We observe that subjects default less than optimal, and this decision is significantly affected by social norm concerns in the context of the experiment. Individuals under-consume in the first periods of life: they are “cautious” when indebted. Both introducing a 50% probability of recourse and a Responsible Homeowner Reward are very effective in preventing default in the lab, especially by individuals receiving a bad shock to income when house prices are low.

Financial market development and firm investment in tax avoidance: Evidence from credit default swap market

Abstract Lenders reduce their monitoring efforts after hedging their credit risk exposure through credit default swap (CDS) contracts, which are akin to insurance against borrowers’ adverse credit events. In this study, we examine whether, upon observing the reduced lender monitoring following CDS trading, shareholders demand that borrowing firms invest in more aggressive tax planning strategies, which were previously constrained by risk-averse lenders. Using a difference-in-differences design that exploits the variation in timing of the inception of CDS trading, we document that borrowers exhibit greater tax avoidance after the inception of CDS trading. Consistent with shareholders stepping up their demands post-CDS, we find that the increase in tax avoidance is stronger for (i) firms with more powerful and influential shareholders, as measured by dedicated institutional investors, (ii) firms with stronger shareholder defenders, as measured by board independence and board size, and (iii) firms with more strategic default options. We also find that borrowers with higher levels of tax avoidance are less likely to file for bankruptcy in the future. Our findings are robust to a battery of sensitivity checks, including controlling for cost of debt and endogeneity, as well as using alternative measures of tax avoidance.

Transparency and Collateral: The Design of CCPs' Loss Allocation Rules

This paper adopts a mechanism design approach to study optimal clearing arrangements for bilateral financial contracts in which an assessment of counterparty risk is crucial for efficiency. The economy is populated by two types of agents: a borrower and lender. The borrower is subject to limited commitment and holds private information about the severity of such lack of commitment. The lender can acquire information at a cost about the commitment of the borrower, which affects the assessment of counterparty risk. When truthful revelation by the borrower is not incentive compatible, the mechanism designer optimally trades off the value of information about the lack of commitment of the borrower with the cost of incentivizing the lender to acquire such information. Central clearing of these financial contracts through a central counterparty (CCP) allows lenders to mutualize their counterparty risks, but this insurance may weaken incentives to acquire and reveal informatio n about such risks. If information acquisition is incentive compatible, then lenders choose central clearing. If it is not, they may prefer bilateral clearing to prevent strategic default by borrowers and to economize on costly collateral. Central clearing is analyzed under different institutional features observed in financial markets, which place different restrictions on the contract space in the mechanism design problem. The interaction between the costly information acquisition and the limited commitment friction differs significantly in each clearing arrangement and in each set of restrictions. This results in novel lessons about the desirability of central versus bilateral clearing depending on traders' characteristics and the institutional features defining the operation of the CCP.

Housing attributes and relative house prices in Ghana

PurposeThe study of house prices has become more relevant in recent times after the global financial crisis. Using a housing data set from three regions of Ghana (collated from real estate agents), the purpose of this paper is to estimate the relative importance of housing attributes to house prices.Design/methodology/approachThe hedonic regression analysis conducted indicates that location is the most powerful determinant of house prices. Other relevant factors are the number of bedrooms, the number of floors, the total floor area, land size, age of the house and luxury finishing.FindingsThe implications of these results are many. Policy wise, the study provides an evidence-based empirical study that supports the need for better urban planning to improve communities, which in turn is associated with house price appreciations. Homeowners, investors and creditors, particularly mortgage lenders could be the immediate beneficiaries. Drawing on this, improved urban planning could mitigate strategic defaults that results from house prices falling below mortgage loan balances. This is important for financial market stability.Originality/valueThe paper provides a comprehensive and unique understanding of the hedonic determinants of house prices in Ghana. Future studies could examine the effect of location upon mortgage lending in Ghana.

Mortgage Modification and Strategic Behavior: A Contrarian Reading of the Countrywide Financial Corporation Settlement

Christopher Mayer, Edward Morrison, Thomas Piskorski and Arpit Gupta of Columbia University have recently published in the Law and Finance eJournal a comprehensive study demonstrating the significant impacts on strategic default rates of the widely publicized Countrywide Financial Corporation settlement of 2008. While their study is comprehensive and carefully done, their implicit assumption that strategic defaults are something to be discouraged rather than encouraged, a position that I have criticized in my earlier work, undercuts the usefulness of their work for policy guidance. From their perspective the Countrywide settlement provides a cautionary tale about difficult trade-offs to be faced in loan modification policy design, whereas I regard it instead as providing some encouragement regarding loan modification initiatives.

Real Option, Debt Agency Conflicts and Corporate Investment Decisions

This paper studies enterprise investment decisions under debt agency conflicts by the method of real option. It is different from the existed literatures that this paper considers not only the influence of investment goals alienation on investment decisions without bankruptcy agency, but also analyzes the investment decisions distortion under bankruptcy agency conflicts. The study result shows that enterprises with debt usually exist overinvestment; on the one hand, the overinvestment comes from excessive pursuing of the tax benefits under the investment goals alienation, on the other hand, it comes from the protection for shareholders’ investment risk under strategic default bankruptcy. What’s more, under the lower debt level, the former is the dominant mechanism for investment decisions distortion; while under the higher debt level, the influence of the later is prominent.

Consequences of Debt Forgiveness: Strategic Default Contagion and Lender Learning

ABSTRACTI use a unique data set of loans to small business owners to examine whether lenders face adverse consequences when they grant debt forgiveness to borrowers. I provide evidence consistent with borrowers communicating their debt forgiveness to other borrowers, who then more frequently strategically default on their own obligations. This strategic default contagion is economically large. When the lender doubles debt forgiveness, the default rate increases by 10.9% on average. Using an exogenous shock to the lender's forgiveness policy, my findings suggest that as the lender learns about the extent of borrower communication the lender tightens its debt forgiveness policy to mitigate default contagion.

Trade Credit in an Overconfident Supply Chain

We propose a price-only trade credit model in an overconfident supply chain with a price-setting newsvendor. Stackelberg equilibrium in different scenarios are derived, respectively. The retailer’s pricing power prevents the manufacturer from squeezing all profit. When the manufacturer knows the retailer holds a different overconfidence parameter, the optimal wholesale price decreases in the manufacturer’s overconfidence, while when the manufacturer believes that the retailer holds the same overconfidence parameter as it, this monotonicity may not be valid. Bilateral overconfidence may partially coordinate the supply chain. Retailer’s strategic default induces a higher wholesale price, while its impacts on the equilibrium retail price and order quantity depend on the bankruptcy cost coefficient. We present the impacts of the manufacturer’s capital constraint and retailer’s risk-aversion.

Strategic Default in the International Coffee Market*

This article studies strategic default on forward sale contracts in the international coffee market. To test for strategic default, we construct contract-specific measures of unanticipated changes in market conditions by comparing spot prices at maturity with the relevant futures prices at the contracting date. Unanticipated rises in market prices increase defaults on fixed-price contracts but not on price-indexed ones. We isolate strategic default by focusing on unanticipated rises at the time of delivery after production decisions are sunk and suppliers have been paid. Estimates suggest that roughly half of the observed defaults are strategic. We model how strategic default introduces a trade-off between insurance and counterparty risk: relative to indexed contracts, fixed-price contracts insure against price swings but create incentives to default when market conditions change. A model calibration suggests that the possibility of strategic default causes 15.8% average losses in output, significant dispersion in the marginal product of capital, and sizable negative externalities on supplying farmers.

Liquidation policy and credit history in financial contracting: An experiment

In the presence of contract incompleteness and asymmetric information, liquidation policy plays an important role in financial contracting. Liquidation is a double-edged sword. It deters borrowers from defaulting strategically, but it could be harsh to borrowers experiencing short-term liquidity problems. This paper presents an experimental analysis of the impacts of (1) liquidation policy on borrowers’ incentive to engage in strategic default and (2) disclosure of credit history information on lending relationships and borrowers’ behaviors. We show that liquidation policy deters borrowers from defaulting strategically. The availability of credit information softens the liquidation policy when the equilibrium liquidation policy is relatively lenient and helps to reduce strategic defaults.

Stress Testing the German Mortgage Market

This paper presents a framework for estimating losses in the residential real estate mortgage portfolios of German banks. We develop an EL model where LGD estimates are based on current collateral values and PD dynamics are estimated using a structural PVAR approach. We confirm empirically that foreclosure rates are rising with the unemployment rate and are inversely related to house price inflation. Being consistent with our expectation that strategic defaults do not play a central role given the full personal liability of German households, the results give broad support for the double-trigger hypothesis of mortgage defaults. In order to analyse the possible credit losses stemming from residential mortgage lending we then use the model to run a top-down stress test and simulate losses on the individual bank level for the years from 2018 to 2020 for the whole German banking sector. Our results show that loss rates in the residential mortgage portfolios of German banks do increase significantly in an adverse economic environment. The estimated expected losses are widely distributed in the banking system leading, on average, to a 0.4 percentage points reduction in the CET1 ratio over the simulation period.

Self-inflicted debt crises

Optimal resolution of debt crises requires bailouts to account for borrowers’ time-inconsistency. We show in a dynamic model of strategic default that myopic borrowers undervalue their option to default by a U-shaped error, which causes excessive leverage, imperfect consumption smoothing, underinvestment in normal times, and risk shifting in crisis times. Optimal bailouts either punish or reward myopia through smaller or larger transfers, leading to procrastinated default and protracted crises or the reverse, depending on whether financial transfers exacerbate or alleviate the borrowers’ misperception of default risk. The model shows that borrowers and lenders ultimately self-inflict debt crises through their strategic interaction, myopic distress can be cheaper to resolve than rational distress, and myopia can benefit stakeholders.

Financial Market Development and Firm Investment in Tax Avoidance: Evidence from Credit Default Swap Market

Lenders reduce their monitoring efforts after hedging their credit risk exposure through credit default swap (CDS) contracts, which are akin to insurance against borrowers’ adverse credit events. In this study, we examine whether, upon observing the reduced lender monitoring following CDS trading, shareholders demand that borrowing firms invest in more aggressive tax planning strategies, which were previously constrained by risk-averse lenders. Using a difference-in-differences design that exploits the variation in timing of the inception of CDS trading, we document that borrowers exhibit greater tax avoidance after the inception of CDS trading. Consistent with shareholders stepping up their demands post-CDS, we find that the increase in tax avoidance is stronger for (i) firms with more powerful and influential shareholders, as measured by dedicated institutional investors, (ii) firms with stronger shareholder defenders, as measured by board independence and board size, and (iii) firms with more strategic default options. We also find that borrowers with higher levels of tax avoidance are less likely to file for bankruptcy in the future. Our findings are robust to a battery of sensitivity checks, including controlling for cost of debt and endogeneity, as well as using alternative measures of tax avoidance.

How Legal and Institutional Environments Shape the Private Debt Renegotiation Process?

I investigate how legal and institutional conditions around loan origination influence a private debt renegotiation process. Using a large sample of 15,000 loans on the European credit market, I apply a sequential logit model to consider the renegotiation likelihood, the conditional probability of multiple renegotiation rounds or multiple amended terms, and the renegotiation outcomes conditional on specific loan amendments. I find that legal systems with stronger protection of creditors control rights have a positive influence on renegotiation likelihood and favorable outcomes on amendments to amount or maturity. Stronger legal protection reduces renegotiation likelihood when creditors face potential strategic default by shareholders. The legal and institutional environment has a significant effect on how the initial design of the financial contract impacts the renegotiation process.

Strategic Default, Investment and the Resolution of Financial Distress

In recent years the U.S. experienced an increase in the share of default events that are resolved out-of-court, as well as a reduction in bankruptcy-related costs. This trend raises the question as to what drives the frequency with which defaults turn into bankruptcies. We propose a theory based on three pillars: first, bankruptcy is costlier than out-of-court restructuring; second, creditors cannot commit to take defaulting borrowers to court; third, firms have private information about the value of their assets, outside investors only learn them only upon bankruptcy. Creditor’s bargaining power upon default decreases with bankruptcy costs and it increases with the frequency of strategic default – that is, default by firms which could have honored their obligations. When bankruptcy costs decrease, creditors obtain higher recovery rates out-of-court and therefore firms have lower incentives to default strategically. As a result, bankruptcy can occur less frequently.

Using Online Search Queries in Real Estate Research with an Empirical Example of Arson Forecast

In this paper, I introduce a user's guide to Google Trends, a service created by Google to make statistics about online searches available to everyone at no cost. I review the service's advantages over conventional sources of data from a researcher's point of view. I also cover the most important stages of a real estate study that employs online search statistics from Google in a step-by-step user's guide. In the guide, I discuss how to compose and refine a list of search terms and how to access, download, process, and apply online search data in real estate research. I illustrate each step of an empirical real estate study. In the study, I test whether the intensity of online searches for specific keywords in metropolitan statistical areas (MSAs) can help to forecast future arson incidents in those areas. The findings reveal that lagged searches for “foreclosure” are significantly positively associated with the number of arson incidents in the same MSA where online searches have been conducted. The findings also show that lagged searches for “arson,” “restructuring,” and “strategic default” are negatively related to the number of intentional property fires.

TIME‐VARYING VOLATILITY, DEFAULT, AND THE SOVEREIGN RISK PREMIUM

AbstractThis article studies how volatility changes affect sovereign spreads in strategic default models. Volatility changes affect savings and sovereign spreads. However, the impact of volatility shocks is state dependent; when the economy has a low debt, an increase in volatility is prone to generate precautionary savings. Instead, with high debt, an increase in volatility is likely to induce an even further increase in debt and spreads, both in endowment and production economies. I document a positive correlation between sovereign spreads and aggregate income volatility for a set of European economies during the debt crisis, consistent with the model's implications.

Communication and Hidden Action: Evidence from a Person-to-Person Lending Experiment

We report the results of a laboratory experiment which examines the impact of pre-contractual communication in person-to-person lending. We show that potential hidden action undermines the positive effect of communication on repayment behavior and credit provision. When strategic defaults by borrowers are revealed to lenders, pre-contractual communication reduces strategic default and increases credit provision. When strategic defaults are hidden behind a veil of uncertainty, we find a substantially weaker impact of communication. Borrowers are more likely to renege on repayment promises when they can hide opportunistic behavior from lenders. These findings have important implications for the design of lending relationships and procedures: Pre-contractual communication and post-contractual monitoring go hand in hand.

International Real Estate Review

This paper demonstrates, theoretically and empirically, that shared equity mortgages are a better affordable housing solution than high-leverage lending, in terms of both default reduction and cost to mortgage insurers. Their effectiveness in reducing strategic default is increased when shared equity contracts are conducted in expensive house price areas, during housing bubble periods, with long holding terms, or for borrowers with high expected returns. The paper develops numerical examples with the use of simulation and back-testing, which are applied to Los Angeles. The results show that Los Angeles could have avoided many of its strategic defaults in the recent recession if it had used a shared equity mortgage as an alternative to conventional low down-payment mortgages.

Collateral Value and Strategic Default: Evidence From Auto Loans

I analyze the impact of changes to collateral value on borrowers' default decision on auto loans using two types of natural experiments in Sri Lanka. Changes in vehicle import tax rates and loan-to-value ratio caps on auto loans generated plausibly exogenous variation in the resale value of vehicles already pledged as collateral. Using proprietary auto loan performance data, I estimate that a 10% drop in the collateral value corresponds to a 44% increase in the default rate. I also find that collateral value is more important for borrowers with higher outstanding loan balances.