Strategic Default Research Articles

Informal Bankruptcy: Health Expenditure Shocks and Financial Distress Avoidance

This article studies the financial decision-making behavior of U.S. families that have difficulties paying for their medical bills and investigate what alternatives they have to avoid filing for formal bankruptcy and what influence their motivation to do so. Using household financial and demographic information from the Health Tracking Household Survey in 2007 and 2010, this article finds that families with younger age members, minority ethnic background, more doctor visits, and without insurance made more diverse and severe choices to finance the payments before resorting to personal bankruptcy. Interestingly, households with better education seek more diverse but easier financing methods, suggesting that financial literacy may play a dual role in undertaking financial planning—strategic default and bankruptcy avoiding.

Energeia, Kinesis, and the Neoliberal Rhetoric of Strategic Default

ABSTRACTRecently, rhetoricians have explored the potential of energeia to unfold new understandings of agency and highlight the mutability of rhetorical topoi. This article harnesses such potential to neoliberal rhetorical analysis, examining the “strategic default” debate that dominated the later foreclosure crisis. Tracing the constitution of a moralized binary distinction between intentional and forced default, I argue that the kinesthetic metaphor of “walking away” from underwater houses disciplines consumers while disclosing the latent potentiality for rational actors to abuse their power of choice. To counter this denial of agency, I draw possibilities for resistant practice from de Certeau’s theory of everyday life.

Energeia, Kinesis, and the Neoliberal Rhetoric of Strategic Default

ABSTRACT Recently, rhetoricians have explored the potential of energeia to unfold new understandings of agency and highlight the mutability of rhetorical topoi. This article harnesses such potential to neoliberal rhetorical analysis, examining the “strategic default” debate that dominated the later foreclosure crisis. Tracing the constitution of a moralized binary distinction between intentional and forced default, I argue that the kinesthetic metaphor of “walking away” from underwater houses disciplines consumers while disclosing the latent potentiality for rational actors to abuse their power of choice. To counter this denial of agency, I draw possibilities for resistant practice from de Certeau’s theory of everyday life.

Rhetoric and Economics, Analysis and History

Rhetoric and Economics, Analysis and History

Sovereign bond spreads and extra-financial performance: An empirical analysis of emerging markets

This paper studies the impact of a country's extra-financial performance on its sovereign bond spreads. Sovereign bond spreads reflect both an economic default risk and a strategic default risk. We hypothesize that a country's extra-financial performance reduces default risk by signalling good commitment ability. We test this hypothesis for the countries which bonds are included in the JP Morgan Emerging Markets Bond Index Global. Over the period from 2001 to 2010, we find that an emerging country's average cost of capital decreases with its governance and social performance. Furthermore, we demonstrate that a good social performance signals an emerging economy's long-term orientation and commitment to repay its debt in the future.

Credit Insurance, Distress Resolution Costs, and Bond Spreads

AbstractCredit default swaps (CDS) introduce friction in debt renegotiations as they alter the incentives of creditors insured with CDS to favor bankruptcy instead of restructuring debt out of court. Such renegotiation friction can increase bond spreads by increasing distress resolution costs. Alternatively, they can decrease bond spreads by deterring the firm from strategic default. Using newly available data on firm‐level CDS positions to proxy for the extent of CDS insurance, we find that bond spreads increase with CDS insurance. Additional tests indicate that this increase is associated with the effect CDS insurance has on increasing distress resolution costs. These results, which are robust to endogeneity concerns associated with CDS insurance, provide evidence that credit insurance can affect a firm's cost of debt.

Transparency and Collateral: Central versus Bilateral Clearing

Bilateral financial contracts typically require an assessment of counterparty risk. Central clearing of these financial contracts allows market participants to mutualize their counterparty risk, but this insurance may weaken incentives to acquire and to reveal information about such risk. When considering this trade-off, participants would choose central clearing if information acquisition is incentive compatible. If it is not, they may prefer bilateral clearing, when this choice prevents strategic default while economizing on costly collateral. In either case, participants independently choose the efficient clearing arrangement. Consequently, central clearing can be socially inefficient under certain circumstances. These results stand in contrast to those in Achary and Bisin (2014), who find that central clearing is always the optimal clearing arrangement.

Walking away from an American Dream, or how a million strategic defaults helped America rethink homeownership

ABSTRACTThis essay examines the relationship between homeowners strategically defaulting on their mortgages and a public shift in the American Dream of homeownership. It argues that the spike in strategic defaults from 2007 to 2011 constituted de facto performative enthymemes about (1) the legitimacy of defaulting on a mortgage and (2) the American Dream of homeownership's declining cultural hegemony. National news reports identified the trend and filled in the enthymemes for a national audience. The enthymemes legitimized homeowners’ decisions to abandon their properties by treating homeownership as an investment, a move which utilized the neoliberal logic of capital against the interests of capital. This essay explains performative enthymemes, probes the cultural development of the American Dream of homeownership, and assesses the enthymemes produced by strategic defaults and outlined in national news reports.

Collateral Value and Strategic Default: Evidence from Auto Loans

Collateral Value and Strategic Default: Evidence from Auto Loans

The Social Life of Mortgage Delinquency and Default

Although falling behind on a mortgage loan has significant personal consequences, we know little about whether the experience of delinquency or default influences the housing market behavior of other people in the defaulter's social networks. In this article, I ask how exposure to mortgage default through social networks affects perceptions of the housing market, judgments about the strategic default behavior of other households, and expectations for homeownership. Although individuals purposively draw on information from their social networks to aid in their housing search, theories of social influence have yet to be applied to the negative experience of mortgage delinquency or default. Drawing on the National Housing Survey, I find that individuals exposed to mortgage strain through their social networks express more negative expectations for the housing market and hold more permissive attitudes about strategic default. Homeowners reporting network exposure to mortgage strain are more likely to prefer rental housing when they next move. These results are strongest when individuals are connected to someone who has fallen behind on a mortgage payment in the previous three months.

Falling Behind: Bank Data on the Role of Income and Savings in Mortgage Default

For many American households, buying a home is one of the largest sources of debt. We use mortgage data at the individual borrower level joined to their deposit account data to investigate the relationship between income shocks and default for borrowers with different levels of home equity, income, payment burden, and savings. First, we find that mortgage default closely followed a negative income shock regardless of a borrower’s level of home equity, income, or payment burden (as measured by total debt-to-income at origination). This provides suggestive evidence against a simple model of strategic default where deeply underwater borrowers stop making mortgage payments only because they are underwater. Second, we find that deeper and longer duration negative income shocks were associated with increasing delinquency. To the extent that homeowners income recovered quickly, they promptly resumed making mortgage payments, while those who suffered longer, deeper income shocks fell further into delinquency. Third, default rates for homeowners with smaller financial buffers were higher regardless of their income level or payment burden. The default rate for borrowers with less than the one mortgage payment equivalent held in reserve was 7 times higher than the default rate for borrowers with at least four mortgage payments in reserve. Half of homeowners who defaulted had fewer than 1.4 mortgage payment equivalents held in reserves, and this was true across all levels of total DTI at origination. These findings suggest that a policy based on maintaining a minimum post-purchase financial buffer may be a better approach to default prevention than underwriting standards based on measuring the borrowers’ static ability-to-repay at origination.

Mortgage Modifications after the Great Recession: New Evidence and Implications for Policy

In the aftermath of the Great Recession, various mortgage modification programs were introduced to help homeowners struggling to make their monthly mortgage payments remain in their homes. We use mortgage data at the individual borrower level, joined to credit card spending and deposit account data, to investigate the relative importance of changes in monthly mortgage payments and long-term mortgage debt on default and consumption. We first quantify the variation in payment reduction offered by these modification programs and then use the variation in payment and principal reduction experienced by program recipients to estimate the impact of payment and principal reduction on default and consumption. First, we find that payment reduction for borrowers with similar payment burdens varied by two to three times across different modification programs. Borrowers with a high mortgage payment to- income (PTI) ratio received more than twice the payment reduction from HAMP compared to the GSE program. Borrowers with a low mortgage PTI ratio received three times the payment reduction from the GSE program compared to HAMP. Second, a 10 percent mortgage payment reduction reduced default rates by 22 percent. Third, for borrowers who remained underwater, mortgage principal reduction had no effect on default. This suggests that “strategic default” was not the primary driver of default decisions for these underwater borrowers. Fourth, for borrowers who remained underwater, mortgage principal reduction had no effect on consumption. Finally, default was correlated with income loss, regardless of debt-to-income ratio or home equity. Mortgage default closely followed a substantial drop in income. This pattern held regardless of pre-modification mortgage PTI or loan-to-value ratio, suggesting that it was an income shock rather than a high payment burden or negative home equity that triggered default. These findings suggest that mortgage modification programs that are designed to target substantial payment reduction will be most effective at reducing mortgage default rates. Modification programs designed to reach affordability targets based on debt-to-income measures without regard to payment reduction or target a specific LTV ratio while leaving borrowers underwater may be less effective at reducing defaults. Furthermore, policies that help borrowers establish and maintain a suitable cash buffer that can be used to offset an income shock could be an effective tool to prevent mortgage default. Both high and low mortgage PTI borrowers experienced a similar income drop just prior to default, suggesting that even among those borrowers with “unaffordable” mortgages, it was a drop in income rather than a high level of payment burden that triggered default.

Credit Default Swaps, Agency Problems, and Management Incentives

We show in a theoretical model that credit default swaps induce managerial agency problems through two channels: reducing the opportunity for managers to transfer value to equityholders from creditors via strategic default, and reducing the intensity of monitoring by creditors, which leads to greater CEO diversion of assets as perquisites. We further show that boards can use compensation awards that increase managerial performance incentives (delta) and risk-taking incentives (vega) in order to mitigate these two agency problems, with increases in managerial vega being particularly useful to alleviate the strategic default-related agency problem. We study equity compensation awards to CEOs of S&P 1500 companies during 2001-2015 and find that they occur in patterns consistent with these predictions.

A Continuous Time Model of Sovereign Debt

I construct a continuous time model of strategic default and provide a numerical algorithm that solves it. I compare the results and computation times to standard discrete time models of sovereign debt. The method proposed here is faster than discrete time computation methods while obtaining similar quantitative results. The few differences between the models can all be attributed to a feature in continuous time that is absent in discrete time, costly deleveraging. I solve three variants of the model. The first includes short term maturity bonds only and a constant risk-free interest rate. The second allows for stochastic fluctuations in the risk-free rate. Finally, I extend the model to allow for long term maturity bonds.

Optimal Group Size in Joint Liability Contracts

We develop a model of repeated microcredit lending to study how group size affects optimal group-lending contracts with joint liability. In the setting being studied, a benevolent lender provides microcredit to a group of borrowers to invest in projects. The outcome of each risky project is not observable by the lender; therefore, if some of the borrowers default on their loan repayments, the lender cannot identify strategic default. The group will be entitled to a subsequent loan if total loan obligation is met. We characterize the optimal contract and determine the optimal size of the borrowers’ group endogenously. We find that although joint liability contracts are feasible under a smaller set of parameter values than individual liability contracts, joint liability has positive effects on the borrowers’ repayment amount and welfare. Our analysis also suggests that group size should increase with project risk. Furthermore, we analyze the effects of partial joint liability, less severe punishment, and project correlation on the feasibility and characteristics of joint liability contracts. Our results show that, first, although partial joint liability has a negative effect on the borrowers’ repayment amount and welfare, it can increase the loan ceiling of joint liability when collusion is not as likely, or when borrowers have high discount factors. Second, less severe punishment does not affect the borrowers’ repayment amount or welfare, but decreases the loan ceiling of joint liability. However, these negative effects created by partial joint liability and less severe punishment on the borrowers’ repayment amount, borrowers’ welfare, and loan ceiling can be offset by forming larger groups. Third, we also found that project correlation allows a higher loan ceiling in larger groups.

A Search for the Genetic Contributors to Strategic Mortgage Default: The Catechol-O-Methyltransferase (COMT) Gene

This study is the first in real estate to identify a specific genetic marker with a significantly greater association for individuals who are more likely to strategically default on their underwater mortgage. The catechol-O-methyltransferase (COMT) gene produces an enzyme that regulates dopamine levels (among many other chemicals) in the prefrontal cortex of the brain. I find that borrowers who have one or two of the “A” alleles (or more formally, the “methionine” allele) are significantly more likely to strategically default than those who possess the “G” (or “valine”) allele. I find no significant association for the DRD4 7-repeater or the 5-HTTLPR markers. My hope is that future researchers will build upon this seminal study to better understand whether borrower strategic defaults are more a function of nature or nurture. Reconciling this difference has tremendous policy implications.

A Revealed Preference Approach to Estimating Strategic Mortgage Default

Many borrowers make extra principal payments on their mortgages (curtailers). Some of these curtailers subsequently go through foreclosure and lose any benefits from their curtailments. Such curtailers reveal ex-ante non-strategic preferences towards default. We contrast the default sensitivity to leverage of curtailers vis-a-vis noncurtailers to isolate the strategic component of default. Our results show between 2008 and 2012 that the strategic component of default was less than 27% of overall default. We demonstrate robustness of the findings to measures of borrower liquidity, sample compositions, and legal settings that shift the value of strategic default.

Joint liability in a classic microfinance contract: review of theory and empirics

PurposeThe purpose of this paper is to investigate the role of joint liability in improving the repayment performance of a microfinance program.Design/methodology/approachThis is a systematic review of the theoretical and empirical literature.FindingsThe theoretical literature has shown, using models of peer selection, peer monitoring and peer pressure, that joint liability overcomes both the informational and enforcement failures present in credit markets for the poor. However, the empirical literature does not yield a clear answer on how much of the success of microfinance programs can be attributed to the effect of joint liability alone without considering the effect of other instruments used by microfinance programs. Further, it is seen that joint liability does not work in isolation, but its effect is dependent on social, cultural and economic environment.Research limitations/implicationsAn important future research agenda could be to study the roles of different overlapping mechanisms in group lending and to look at their interactions.Practical implicationsThe concept of joint liability works well both in the rural and urban areas, but different social, cultural and economic factors should be analyzed before initiating a microfinance program. In developed regions, focus should be on strengthening peer selection and peer monitoring, as information problems are prevalent. In underdeveloped regions, the major problem is of strategic default, so the focus should be on strengthening social sanctions.Social implicationsFindings can be used for optimal design of credit contracts for the poor.Originality/valueThe paper reviews the existing literature on – “whether and how” – joint liability lending works in inefficient credit markets and comes up with practical implications for the microfinance sector.

Deficiency Judgments as a Mortgage Pricing Factor

AbstractThe subject of the deficiency judgments has been poorly examined due to a lack of relevant data and the complexity of the issue. Some comprehensive studies have explored whether allowing deficiency judgments decreases the likelihood of strategic defaults in the U. S. mortgage market. Little, however, has been done to determine whether there is any direct correlation between legal standing allowing recourse and loan pricing. Hence, additional work regarding this subject is needed.This study seeks to fill this gap by exploring the impact of allowing deficiency judgments on mortgage pricing policy in various U. S. states. Seven distinctive mortgage types in two groups of states were compared. We conclude that there is no statistically significant difference between recourse and non-recourse states in terms of mortgage pricing, regardless of mortgage type.

Credit Derivatives and Firm Investment

We examine the effect of credit default swap (CDS) trading on firm investment, finding a post-CDS introduction decrease in debt issuance and acquisitions, which remains robust to propensity score matching, instrumenting CDS introduction, and controlling for past investment and financing activities. Further analysis reveals a CDS introduction-year increase in debt financing and acquisitions, for which we could not eliminate reverse causality as a potential explanation. Overall, the ex post increase in bankruptcy risk and debt overhang likely plays a dominant role in the investment effect of CDS, while the expansion in credit supply due to a reduction of strategic default or regulatory capital requirement appears less important.