Explicit Tests of Contingent Claims Models of Mortgage Default

This paper provides explicit and powerful tests of contingent claims approaches to modeling mortgage default. We investigate a model of "frictionless" default (i.e., one in which transactions costs, reputation costs and moving costs play no role) and analyze its implications--the relationship between equity and default, the timing of default, its dependence upon initial conditions, and the severity of losses. Absent transactions costs and other market imperfections, economic theory makes well-defined predictions about these various outcomes. The empirical analysis is based upon two particularly rich bodies of microdata: one indicating the default and loss experience of all mortgages purchased by the Federal Home Mortgage Corporation (Freddie Mac) and a large sample of all repeat sales of single family houses whose mortgages were purchased by Freddie Mac since 1976. Copyright 1995 by Kluwer Academic Publishers