Skip to main content
    • Aa
    • Aa

The Principal Principle

  • Sanjiv R. Das (a1)

I analyze optimal loan modification schemes in a stochastic home price and stochastic interest-rate environment. Lenders maximize loan values by managing the borrower’s option to default on the loan and prepayment option. Given negative equity, controlling for the borrower’s ability to pay, rate reductions and maturity extensions result in a higher probability of redefault by homeowners even after modification of their loans. In contrast, loan write-downs (the Principal Principle), not a favored recipe, are value maximizing for the lender. A shared-appreciation mortgage enhances the ability to pay, mitigates adverse selection, and reduces the present value of expected deadweight foreclosure costs.

Linked references
Hide All

This list contains references from the content that can be linked to their source. For a full set of references and notes please see the PDF or HTML where available.

B. W. Ambrose , and C. A. Capone Jr. “Cost-Benefit Analysis of Single-Family Foreclosure Alternatives.” Journal of Real Estate Finance and Economics, 13 (1996), 105120.

R. W. Anderson , and S. Sundaresan . “The Design and Valuation of Debt Contracts.” Review of Financial Studies, 9 (1996), 3768.

J. Cox ; J. Ingersoll ; and S. Ross . “A Theory of the Term Structure of Interest Rates.” Econometrica, 53 (1985), 385407.

J. C. Cox ; S. A. Ross ; and M. Rubinstein . “Option Pricing: A Simplified Approach.” Journal of Financial Economics, 7 (1979), 229263.

Y. Deng ; J. M. Quigley ; and R. van Order . “Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options.” Econometrica, 68 (2000), 275307.

C. Foote ; K. Gerardi ; L. Goette ; and P. Willen . “Reducing Foreclosures: No Easy Answers.” NBER Macroeconomics Annual, 24 (2009), 89138.

A. C Ghent . “Securitization and Mortgage Renegotiation: Evidence from the Great Depression.” Review of Financial Studies, 24 (2011), 18141847.

L. S Goodman . “Dimensioning the Housing Crisis.” Financial Analysts Journal, 66 (2010), 2637.

J. P. Harding ; T. J. Miceli ; and C. F. Sirmans . “Deficiency Judgments and Borrower Maintenance: Theory and Evidence.” Journal of Housing Economics, 9 (2000), 267285.

J. P. Harding ; E. Rosenblatt ; and V. W. Yao . “The Contagion Effect of Foreclosed Properties.” Journal of Urban Economics, 66 (2009), 164178.

J. P. Harding , and C. F. Sirmans . “Renegotiation of Troubled Debt: The Choice between Discounted Payoff and Maturity Extension.” Real Estate Economics, 30 (2002), 475503.

D. Heath ; R. Jarrow ; and A. Morton . “Bond Pricing and the Term Structure of Interest Rates: A Discrete Time Approximation.” Journal of Financial and Quantitative Analysis, 25 (1990),419440.

D. Heath ; R. Jarrow ; and A. Morton . “Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation.” Econometrica, 60 (1992), 77106.

J. B. Kau , and D. C. Keenan . “Patterns of Rational Default.” Regional Science and Urban Economics, 29 (1999), 765785.

J. B. Kau ; D. C. Keenan ; W. J. Muller III; and J. F. Epperson . “A Generalized Valuation Model for Fixed-Rate Residential Mortgages.” Journal of Money, Credit and Banking, 24 (1992), 279299.

A. Mian , and A. Sufi . “House Prices, Home Equity-Based Borrowing, and the U.S. Household Leverage Crisis.” American Economic Review, 101 (2011), 21322156.

T. Piskorski ; A. Seru ; and V. Vig . “Securitization and Distressed Loan Renegotiation: Evidence from the Subprime Mortgage Crisis.” Journal of Financial Economics, 97 (2010), 369397.

Recommend this journal

Email your librarian or administrator to recommend adding this journal to your organisation's collection.

Journal of Financial and Quantitative Analysis
  • ISSN: 0022-1090
  • EISSN: 1756-6916
  • URL: /core/journals/journal-of-financial-and-quantitative-analysis
Please enter your name
Please enter a valid email address
Who would you like to send this to? *