New Zealand Institute for the study of competition and regulation inc.

Abstract

This paper uses a real options approach to analyse the exercise of the default option embedded in mortgages. In particular, it examines the case of a subprime household who borrows at a premium, but hopes to refinance at prime rates if their house appreciates. In a low interest rate environment, this credit-upgrade potential may discourage subprime borrowers from defaulting in situations where a prime borrower would choose to default. This provides a rational explanation for the prevalence of adjustable rate mortgages among subprime borrowers, and the subsequent large numbers of defaults, when interest rates rose and house prices declined.