How Unsecured Credit Policies Influence Mortgage and Unsecured Loan Defaults

• Published date: 01 August 2020
• Author: JISEOB KIM
• Date: 01 August 2020
• DOI: http://doi.org/10.1111/jmcb.12620

DOI: 10.1111/jmcb.12620

JISEOB KIM

How Unsecured Credit Policies Influence Mortgage

and Unsecured Loan Defaults

Before the global financial crisis, the proportion of households defaulting on

the mortgage while remaining current on the unsecured loan was almost the

same as the proportion of households current on the mortgage but defaulting

on the unsecured loan. After the crisis, the former ratio became higher than

the latter. By using a heterogeneous agent model with the mortgage and the

unsecured loan, I examine how the order of defaults changed before and

after the crisis. I then analyze the impacts of unsecured credit policies on

households’ mortgage and unsecured loan defaults. My quantitativeexercise

shows that both default rates can decrease as the cost for unsecured loan

defaults increases.

JEL codes: E21, E44, G01, K35, R21

Keywords: unsecured loan, mortgage, foreclosure, bankruptcy.

BEFORE THE GLOBAL FINANCIAL CRISIS, the proportion of house-

holds defaulting on the mortgage while remaining current on the unsecured loan was

almost the same as the proportion of households current on the mortgage but de-

faulting on the unsecured loan.1During and after the crisis, the former ratio became

much higher than the latter (Komos et al. 2012). In this paper, I quantitativelyanalyze

how the order of defaults can be reversed before and after the crisis. Since the 2007

financial crisis was characterized by a sudden and deep decrease in house prices, it

I thank the editor Sanjay Chugh, two anonymousreferees, and seminar participants at Yonsei University,

the Asian Meeting of the Econometric Society, and the 12th Joint Economics Symposium of FiveLeading

East Asian Universities for helpful comments. This research was supported by the Yonsei University

Research Fund of 2018-22-0015.

JISEOB KIM is an Assistant professor, School of Economics, Yonsei University (E-mail:

jiseob.kim@yonsei.ac.kr).

Received June 18, 2018; and accepted in revised form January 10, 2019.

1. Among many types of household debts, such as mortgages, credit card debts, education loans, auto

loans, lines of credit, and other loans secured by insurance or pension, I mainly focus on mortgages and

unsecured loans. According to the 2007 Survey of Consumer Finances, 29% of households held both

loans simultaneously. Here, the mortgage loan is the value of debt secured by the primary residence. The

unsecured loan is defined by the debt without the need for collateral, such as credit card loans and lines of

credit not secured by homes.

Journal of Money, Credit and Banking, Vol.52, No. 5 (August 2020)

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2020 The Ohio State University

1272 :MONEY,CREDIT AND BANKING

seems to be natural that many mortgage indebted households failed to repay their

mortgages, rather than the unsecured loan. On the other hand, it is also possible that

multiple debtors might prefer to preserve their liquidity for smoothing consumption

by not defaulting on their unsecured credit (Cohen-Cole and Morse 2010, Jagtiani

and Lang 2011, Andersson et al. 2013). Hence, I subsequently examine the impact

of unsecured credit policies—which affect households’ liquidity accessibility—on

the mortgage and unsecured loan defaults.2Lastly, I analyze the effects of these

unsecured credit policies on reducing mortgage defaults during the financial crisis.

The U.S. government initiated several foreclosure prevention programs after the cri-

sis (Robinson 2009, Gerardi and Li 2010). Instead of examining direct debt relief

programs, this paper normatively analyzes the role of liquidity-related policies in

reducing the foreclosure rate.

When multiple debt holders experience financial difficulties, they might default on

the unsecured loan, instead of the mortgage, to retain homeownership and to relieve

unsecured debt payment burden. In exchange, they cannot access the unsecured loan

market for several years and incur partial pecuniary losses as a default penalty. On

the other hand, households with multiple debts can default only on the mortgage loan

to keep the option of borrowing the unsecured loan in the future. Though mortgage

defaulters do not need to pay the periodic mortgage, they lose their homeownership

and cannot access the mortgage market and buy a new house for several years as a

default penalty.Depending on the benefits and costs of each default option, financially

troubled households can make their optimal default decisions.

To analyze impacts of credit policies on the order of defaults, I introduce a quan-

titative model where households can access two types of loans—the mortgage and

the unsecured loan—if eligible, and default on either loans if necessary. When a

renter has good credit records in both credit markets, it can take out the long-term

mortgage to buy a house and the short-term unsecured loan to share income risk. In

my model, the mortgage is used only for purchasing a new house, and the unsecured

credit is used for sharing income risk and smoothing consumption. A homeowner

that has both the mortgage and the unsecured loan can decide whether to repay the

mortgage as contracted, sell the house, or default on the mortgage. In addition, (s)he

can decide whether to repay the unsecured loan or to default. Once the household

defaults on one of two loans, the household’s credit record in the defaulting sector

becomes bad and it cannot access the defaulted loan market for several years as a

penalty. Hence, households can strategically default on one type of loan to access

the other type, depending on the costs and benefits of each default decision. Both

mortgage and unsecured loan lenders take into account households’ repayment and

default possibilities, and offer loan interest rates in a competitive manner.

After calibrating the steady-state economy to match major household finance-

related moments in the early 2000s, I examine how unsecured credit policies impact

2. Changes in credit underwriting processes or policy guidelines might also significantly impact the

order of defaults. However,I mainly focus on the role of liquidity given the lending standard on households’

default decisions.

JISEOB KIM :1273

households’ optimal default decisions during the financial crisis. To analyze this, I

initially consider a benchmark transition that represents the U.S. economy before

and after the financial crisis. First, given the initial steady-state economy, market

participants face the bankruptcy reform in 2005. The Bankruptcy Abuse Prevention

and Consumer Protection Act (BAPCPA) was enacted in 2005, which made it more

difficult for households to file for Chapter 7 bankruptcy. Starting from 2007, the

average house price suddenly decreases for two consecutive years, mirroring the U.S.

financial crisis. Such an unexpected decrease in the house price increases both the

mortgage foreclosure rate and the bankruptcy rate, as was seen in the United States.

Consistent with the data, my model illustrates that the proportion of households

defaulting only on the mortgage becomes higher than that defaulting only on the

unsecured loan, which was the opposite before the crisis.

Next, I consider a counterfactual transition where households that default on the

unsecured loan can easily reaccess the credit market after the financial crisis. By

comparing the benchmark and the counterfactual transitions, I can examine the effects

of improved unsecured credit accessibility on mitigating households’ defaults after

the crisis. Though an increase in accessibility to the unsecured loan market can

relax budget tightness for financially troubled households, it also leads to an increase

in the value of defaulting on the unsecured loan. In turn, marginal households are

more likely to default on their unsecured loan and give up on repaying their debt.

In addition, financially troubled households with multiple debts are more likely

to default on their debts simultaneously, and then reaccessing the unsecured loan

market immediately. This in turn leads to an increase in the mortgage default rate

as well.

However, when households have more difficulty reaccessing the unsecured loan

market after a default, the cost of defaulting on the unsecured loan increases. This

reduces the unsecured loan default rate. At the same time, multiple debtors are less

likely to default on their loans simultaneously, because of the increased cost of

defaulting on the unsecured loan. This in turn leads to a decrease in the mortgage

default rate.

I also consider experimental economies where the postdefault pecuniary cost de-

creases and the BAPCPA is retracted. My quantitative exercises show that these

relaxed policy stances on unsecured credit cannot reduce both default rates after the

financial crisis.

Related Literature. This paper is closely related to and complements Mitman (2016),

who quantitatively examines effectsof bankruptcy and foreclosure policies on house-

holds’ defaults and welfare. However, the main research question and model struc-

tures are quite different. He analyzes state-level default policies and their impact

on households’ default rates. This paper, however, mainly examines whether better

access to liquidity by changing unsecured credit policies can mitigate the prevalence

of mortgage and unsecured loan defaults and alter multiple debtors’ default order