Mortgage Modification and the Decision to Strategically Default: A Game Theoretic Approach
Abstract:While numerous and varied opinions abound, there remains much confusion as to why relatively few mortgages are modified at a time when the demand to modify is historically high. To better understand this complex issue, we build a game theoretic model to quantify a number of economic incentives and costs surrounding critical dimensions of the lender's decision to modify a loan and the borrower's decision to strategically default in an attempt to encourage such a modification. We mathematically demonstrate that it is rarely economically rational for lenders to modify loans. For the borrower, we find that their negative equity position, growth rate in home prices, and the probability the lender will exercise its legal right to recourse represent the top three strategic default determinants.