Strategic Delinquency Options in US Residential Mortgages

Mortgage option theoretic research generally focuses on the valuation of the default and prepayment options. Exercise of the delinquency option is often regarded as an interim step before terminal states of mortgage default or cure and of limited option value in its own right. However, in the current US housing crisis, borrowers may choose to defer a mortgage payment in order to mitigate a cash flow problem or improve their equity position. This option is available when the lender does not automatically foreclose on the delinquent borrower. Invariably, a negotiation commences between lender and borrower, each motivated by different sets of objectives. We model those negotiations by considering future unavoidable foreclosure costs. We derive closed form solutions for the optimal ex ante mortgage loan terms, such as LTV and coupon payment, offered by a lender to a borrower with a strategic delinquency option. We then compare the optimal ex post exercise, in terms of the borrower’s book LTV, of the delinquency option to the exercise of a default option for borrowers with heterogeneous expectations. We show that the ability to negotiate a larger share of unavoidable foreclosure costs in one’s favour has a significant influence on the optimal ex ante financing and ex post delinquency decisions.