The Mortgage Renegotiation Option and Strategic Default

Flanagan, MA (2015) The Mortgage Renegotiation Option and Strategic Default. In: 19th Real Options Conference.

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Abstract

We argue that lenders and policy makers might help mitigate the credit risk associated with strategic default by US residential homeowners by better understanding characteristics of the strategic negotiation option. We extend the commonly valued default and prepayment mortgage option by proposing and developing a strategic renegotiation option, which is related to the more commonly known strategic default option, where we assume an instantaneous renegotiation between portfolio lender and a US residential mortgage borrower triggered by a declining collateral asset value. We model those negotiations by considering and sharing future unavoidable foreclosure costs in a Nash bargaining game. We derive closed form solutions for the optimal mortgage loan terms, such as LTV and coupon payment, offered by the portfolio lender to a residential borrower with a strategic default option. We then compare the optimal exercise moment, in terms of the borrower’s book LTV, of the strategic negotiation option to the exercise of a conventional default option for borrowers with heterogeneous expectations. We show that the ability of either party to negotiate a larger share of unavoidable foreclosure costs in one’s favour has a significant influence on the timing of the optimal ex post default decision.