The Principal Principle
Sanjiv Das ()
Journal of Financial and Quantitative Analysis, 2012, vol. 47, issue 6, 1215-1246
I analyze optimal loan modification schemes in a stochastic home price and stochastic interest-rate environment. Lenders maximize loan values by managing the borrowerâ€™s option to default on the loan and prepayment option. Given negative equity, controlling for the borrowerâ€™s ability to pay, rate reductions and maturity extensions result in a higher probability of redefault by homeowners even after modification of their loans. In contrast, loan write-downs (the Principal Principle), not a favored recipe, are value maximizing for the lender. A shared-appreciation mortgage enhances the ability to pay, mitigates adverse selection, and reduces the present value of expected deadweight foreclosure costs.
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