mortgage default and mortgage valuation.pdf

FEDERAL RESERVE BANK OF SAN FRANCISCO WORKING PAPER SERIES Mortgage Default and Mortgage Valuation John Krainer Federal Reserve Bank of San Francisco Stephen F. LeRoy Federal Reserve Bank of San Francisco Munpyung O University of California, Santa Barbara November 2009 Working Paper 2009-20 /publications/economics/papers/2009/wp09-20bk.pdf The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. Mortgage Default and Mortgage Valuation John Krainer Stephen F. LeRoy Federal Reserve Bank of San Francisco Federal Reserve Bank of San Francisco Munpyung O University of California, Santa Barbara November 2, 2009 Abstract We develop an equilibrium valuation model that incorporates optimal default to show how mortgage yields and lender recovery rates on defaulted mortgages depend on initial loan-to-value (LTV) ratios. The analysis treats both the frictionless case and the case in which borrowers and lenders incur deadweight costs upon default. The model is calibrated using data on California mortgages. Given reasonable parameter values, the model does a surprisingly good job fitting the risk premium in the data for high LTV mortgages. Thus