Loan Loss Severity and Optimal Mortgage Default

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Abstract
This paper tests the contingent claims model of mortgage default in its ruthless or frictionless form. The principal tests of the model are based on an unconventional source of data, namely, loan loss severities on defaulted mortgages. The frictionless model has well‐defined predictions about loss severities which we test in detail. The data analyzed include a random sample of all mortgages originated during the period 1975–90 and purchased by Freddie Mac, as well as the loss severities on all mortgages purchased by Freddie Mac which defaulted during the period. The frictionless model does not do well in these tests.

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