Mortgage default and low downpayment loans: The costs of public subsidy

This paper presents a unified model of the default and prepayment behavior of homeowners in a proportional hazard framework. The model uses the option-based approach to analyze default and prepayment, and considers these two interdepen-dent hazards as competing risks. The results indicate the sensitivity of default o the initial loan-to-value ratio of the loan and the course of housing equity. The latter is a measure of the extent o which the default option is in the money. The results also indicate the importance of trigger events, namely unemployment and divorce, in affecting prepayment and default behavior. The empirical results are used to analyze the costs of a current policy proposal-stimulating homeownership by offering low downpayment loans. We simulate default probabilities and costs on zero-downpay-merit loans and compare them with conventional loans with conventional underwrit-ing standards. The results indicate that if zero-downpayment loans were priced as if they were mortgages with 10 % downpayments, then the additional program costs would be 2-4 % of funds made available-when housing prices increase steadily. If