Equity Dilution: An Alternative Perspective on Mortgage Default

Abstract

Empirical research on mortgage default in the single-family market has focused on the value of the borrower's put option using house price indices to estimate contemporaneous loan-to-value ratio or the probability of negative equity. But since the borrower possesses the option to increase leverage by taking on additional debt secured by junior liens subsequent to loan origination (a phenomenon termed here equity dilution), even a perfect house price adjustment cannot be expected to accurately measure changes in borrower equity over time. Since junior liens are generally unobservable to senior debt holders, proxies are required in empirical applications. This paper employs an independent estimate of junior lien probability developed from the 1998 Survey of Consumer Finances combined with loan level mortgage performance data to examine the role junior liens play in increasing default risk. Copyright 2004 by the American Real Estate and Urban Economics Association

The Performance of Low‐Income and Minority Mortgages

“…Another explanation is a lower degree of mobility for such households, which would be consistent with the results in Goldberg and Harding (2003). Finally, low‐income households may take out additional mortgages more frequently, and high LTV ratios (including all mortgage debt) may prevent refinancing, as discussed in Lacour‐Little (2004).…”

The Performance of Low Income and Minority Mortgages

“…Another explanation is a lower degree of mobility for such households, which would be consistent with the results in Goldberg and Harding (2003). Finally, low-income households may take out additional mortgages more frequently, and high loan to value ratios (including all mortgage debt) may prevent refinancing, as discussed in Lacour-Little (2004). We find credit history is an also an important predictor of prepayment.…”

The Role of Home Equity Lending in the Recent Mortgage Crisis

“…More recent papers include LaCour‐Little () which argues that a borrower's postorigination home equity borrowing dilutes equity increasing the risk of default on the senior debt. In a working paper, LaCour‐Little, Rosenblatt and Yao () report that roughly 80% of Southern California borrowers facing foreclosure during 2006–2008 had at least one junior lien outstanding, suggesting that junior lien borrowing may increase foreclosure risk.…”

“…Studies have shown that junior lien lending through home equity loans is related to the increase in household leverage (Mian and Sufi ) and the decline in personal savings (Greenspan and Kennedy ). Increased debt usage through home equity lending can also dilute equity in a borrower's home, thereby increasing the default risk of first mortgage and magnifying the impact of declining house prices on default and foreclosure rates (LaCour‐Little ). According to a recent CoreLogic negative equity report (CoreLogic ), nationwide aggregate negative equity reached $699 billion in the third quarter of 2011.…”