Modeling and evaluating the credit risk of mortgage loans: a primer

ABSTRACT This paper presents a simple version of the application of option-based pricing models to mortgage credit risk. The approach is based on the notion that default can be viewed as a put option: the borrower gives up the property in exchange for the mortgage. Then the place to look in modeling default is the extent to which the option is in-the-money (the extent to which the borrower has negative equity in the property) and, given that, the incentive, eg, a trigger event and inability to withstand it, to exercise the option. The focus is on how the probability of default can be modeled, how the default risk can be priced and the use of statistical models to evaluate risks and validate risk models. Particular concerns for validation are the underlying structure of the modeling and the possibility of reverseengineering models and moral hazard.