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Abstracts of Papers by Finance Department Faculty Authors: Dennis R. Capozza (Michigan) and Thomas A. Thomson (University of Texas, San Antonio) J Real Estate Finan Econ (2006) 33: 241–258 Abstract: When a mortgage borrower becomes seriously delinquent (i.e., defaults), the lender initiates a time consuming and complex recovery process that may or may not result in foreclosure and eventual disposition of the real estate collateral (REO). This research studies this transition process for a unique sample of subprime mortgages that were seriously delinquent on September 30, 2001. Eight months later, possible states for the delinquent loans, in order, are 1) to remain delinquent without deteriorating further, 2) foreclosure, 3) worsen, i.e., become more months delinquent, 4) bankruptcy and 5) cure. The data indicate that, relative to prime loans, when subprime loans become seriously delinquent (90 days or longer) they are about twice as likely to become REO but take about four times longer to get there. It is unusual for a subprime default to be cured suggesting considerable forbearance by subprime lenders. We explore determinants of the transition probabilities and find that the most economically important predictors of transition from default to any other state are the number of payments the borrower has made and the loan to value ratio. Title: Optimal Stopping and Losses on Subprime Mortgages Authors: Dennis R. Capozza (Michigan) and Thomas A. Thomson (University of Texas, San Antonio) The Journal of Real Estate Finance and Economics, 30:2, 115–131, 2005 Abstract: Lender losses on mortgage loans arise from a two-stage process. In the first stage, the borrower stops making payments if and when default is optimal. The second stage is a lengthy and costly period during which the lender employs legal remedies to obtain possession and execute a sale of the collateral. This research uses data on subprime mortgage losses to explore the role of borrower and collateral characteristics, and local legal requirements, as well as traditional option variables in the decisions of borrowers and lenders. Although subprime borrowers default earlier, which should reduce lender losses, these borrowers, nevertheless, impose greater realized losses on mortgage lenders. Title: Nonparametric Estimation of State-Price Densities Implicit in Interest Rate Cap Prices Authors: Haitao Li (Michigan) and Feng Zhao (Rutgers) Abstract: Based on a multivariate extension of the constrained locally polynomial estimator of Aït-Sahalia and Duarte (2003), we provide one of the first nonparametric estimates of probability densities of LIBOR rates under forward martingale measures and state-price densities (SPDs) implicit in interest rate cap prices. The forward densities and SPDs depend significantly on the slope and volatility of LIBOR rates, and mortgage markets activities have strong impacts on the shape of the forward densities. The SPDs exhibit a pronounced U-shape as a function of future LIBOR rates, suggesting that the state prices are high at both extremely low and high interest rates, which tend to be associated with recessions and high inflations, respectively. Our results provide nonparametric evidence of unspanned stochastic volatility and suggest that the unspanned factors could be partly driven by activities in the mortgage markets. Title: Reduced-Form Valuation of Callable Corporate Bonds: Theory and Evidence Authors: Robert Jarrow (Cornell), Haitao Li (Michigan), Sheen Liu (Washington State Univesity), and Chunchi Wu (University of Missouri and Singapore Mgt University) Abstract: We develop a reduced-form approach for valuing callable corporate bonds by characterizing the call probability via an intensity process. Asymmetric information and market frictions justify the existence of a call-arrival intensity from the market's perspective. Our approach both extends the reduced-form model of Duffie and Singleton (1999) for defaultable bonds to callable bonds and captures some important differences between call and default decisions. We also provide one of the first comprehensive empirical analyses of callable bonds using both our model and the more traditional American option approach for valuing callable bonds. Our empirical results show that the reduced-form model fits callable bond prices well and that it outperforms the traditional approach both in- and out-of-sample.
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