Modeling the Credit Risk of Mortgage Loans: A Primer

Abstract

This paper presents a simple version of the application of option based pricing models to mortgage credit risk. The approach is based on the notion that default can be viewed as exercising a put option, and that the place to look in modelling default is the extent to which the option is in the money (the extent to which the borrower has negative equity in the property) and, given that, the incentive, e.g., a trigger event and inability to withstand it, to exercise the option. The main focus is on how the probability of default can be estimated and how the default risk can be priced. The analysis considers both “first principles” and specific analysis about U. S. default experience.