Affordability vs. in-the-money

There is a view that mortgages default because people have borrowed more than they can afford if, for example, they become unemployed.

There is an alternative view that mortgages default because default is an in-the-money option. After all, that is when options get exercised, isn’t it?

Affordability/Unemployment

In order to have a pure case to discuss, let’s assume that the default option is NOT in-the-money. This means that the homeowner has positive equity in their home. If the homeowner were to become unemployed, would he or she default on the mortgage? No way. That would essentially mean throwing away positive equity. Instead, a rational homeowner who cannot afford his or her mortgage would try to sell their property. If this had to be done in a hurry, they would turn to an investor who would take a cut of the equity in order to sell quickly.

Option in-the-money

Again we must make a pure case. Suppose the owner can afford the mortgage payments, but the default option is in-the-money. The default option is a put option. The in-the-money default option occurs when it is worth more to the owner to put the property to the lender rather than continue to make payments. This means that the property is worth less than the balance due on the mortgage. The option is more likely to be in-the-money if there are high loan to value ratios and non-recourse loans. A non-recourse mortgage is one in which the lender cannot go after the borrower’s other assets if the borrower defaults.

Mashup

Of course, the world is not composed of perfect cases. Unemployment is likely to be high when house prices are low, so the true cause of the default problem is hidden by confusing facts. Nevertheless, if we do not extract the real cause, then we are likely to devise solutions that will not work.