We analyze recently proposed mortgage contracts which aim to eliminate selective borrower default when the loan balance exceeds the house price (the "underwater" effect). We show that contracts which automatically reduce the outstanding balance in the event of local house price decline remove the default incentive, but may induce prepayment in low price states. However, low state prepayments vanish if borrower utility from home ownership , or outside options such as rental costs, are too high. We also show that capital gain sharing features, through prepayment penalties in high house price states, are ineffective , as they virtually eliminate prepayment in such states. For typical foreclosure costs, we find that contracts with automatic balance adjustments become preferable to the traditional fixed rate mortgage at contract rate spreads of approximately 50-100 basis points , depending on how far prices must fall before adjustments are made. Furthermore, these spreads rapidly decrease with the borrower utility from home ownership. Our results are obtained using American options pricing methods , in a  model with diffusive home prices , and either diffusive or constant interest rates. We determine the contract, default and prepayment option values with optimal decision rules  . We provide explicit solutions in the perpetual case with constant interest rates; and numerically compute the prepayment and default boundaries in the general case .
We analyze recently proposed mortgage contracts which aim to eliminate selective borrower default when the loan balance exceeds the house price (the "underwater" effect). We show that contracts which automatically reduce the outstanding balance in the event of house price decline remove the default incentive, but may induce prepayment in low price states. However, low state prepayments vanish if the benefit from home ownership is sufficiently high. We also show that capital gain sharing features, such as prepayment penalties in high house price states, are ineffective as they virtually eliminate prepayment . For observed foreclosure costs, we find that contracts with automatic balance adjustments become preferable to the traditional fixed rate contracts at mortgage rate spreads between 50-100 basis points . Results are obtained using American options pricing method , in a continuous time model with diffusive home prices . Here, we associate the contracts' values and optimal decision rules with free boundary problems . We provide explicit solutions in the long contract maturity limit .
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