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The secondary mortgage market has traditionally focused on prepayment risk. The growth in the nonagency market in recent years, especially the subprime sector, has led to increased interest in mortgage credit analysis, a trend accelerated by the recent turmoil in the subprime market. A key component of mortgage credit analysis is a loss severity model, which predicts the likely loss when a mortgage defaults. This article describes a loss severity model that we have developed, using loan level analysis of several hundred thousand defaulted loans combined with extensive research into state level costs and timelines associated with mortgage defaults.1
The loss from a mortgage default can be simply stated as:
Loss = Loan Balance + Costs - Property Sales Price - Mortgage Insurance Payment
This simplicity is deceptive - the phrase "the devil is in the details" was never more applicable than here. Other than the loan balance, each of the terms depends on myriad factors, such as mortgage and property characteristics, state laws, local taxes and expenses, servicing contract details, and so on. In addition, the sale price of the property is subject to several levels of adverse selection.
THE PATH OF A DELINQUENT LOAN
A mortgage servicer handles the process of collecting and managing monthly payments and remitting them to mortgage investors.2 If borrowers miss a payment, the servicer will contact them to determine the reasons for the missed payments and to decide on the best course of action. The goal is to try to cure the loan (that is, make it current again); the servicer will work with the homeowner to achieve this, and may even offer to recast or modify the loan.
Short sale. If efforts to cure the loan are not successful, and several payments are missed, the loan is termed to be seriously delinquent. Typically, delinquent borrowers that have positive equity in their home will either refinance or sell off their property to cover the outstanding balance. However, if they have little or no equity left in the property, those options are not available to them. In such a case, the servicer can encourage the homeowner to sell the property and may even agree to write off the remaining balance and late fees depending on the agreement between...