Adversity or Strategy?: The Effects of Credit Constraint and Expectation on Mortgage Default and Personal Bankruptcy Decisions A thesis submitted by Yoshiyuki Miyoshi In partial fulfillment of the requirements for the degree of Master of Arts in Economics

TUFTS UNIVERSITY May 2008

Advisor: Yannis Ioannides

Abstract This thesis contributes to the literature on mortgage default and personal bankruptcy with empirical findings, which disentangle the two mainstream theories: the willingness-to-pay theory and the ability-to-pay theory. The emphasis is on credit constraints and insolvency in order to integrate these two theories. The estimation results of a model of simultaneous choices between mortgage and nonmortgage delinquency suggest that credit constraints and borrowers’ insolvency are the bridge between the two conflicting theories. I also find the importance of backward-looking expectations and the homestead exemption in households’ decisions on mortgage default and bankruptcy. In addition, with a model of bankruptcy decisions, I show that credit constrained and seriously financially distressed households act more “ruthlessly” based on their financial benefit from bankruptcy filings.

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Acknowledgment I would like to express my sincerest gratitude to my advisor, Professor Yannis Ioannides, whose patience, enthusiasm, expertise, and guidance, have added considerably to my research experience. Beginning with a class of graduate macroeconomics under his direction, in which I wrote a research paper in economics for the first time in my life, he has helped me make significant academic progress in organizing and developing my ideas and thoughts. He was also the one who inspired me to work on mortgage default and personal bankruptcy, which I never knew that was such an exciting subject as it is. Without his encouragement and support, I would not have been able to write this thesis. I would like to thank Professor Gilbert Metcalf for all his guidance. While working as a research assistant for him, I learned what professional economic research is like. I would also like to thank Professor Jeffrey Zabel and Professor Edward Kutsoati for their insightful comments during the defense. I would also like to show my appreciation to Professor Joshua Fischman for his support for this project. I am also grateful for the guidance of my academic advisor, Professor Marcelo Bianconi, in the pursuit of the master’s program in economics at Tufts. I am greatly indebted to the Ministry of Land, Infrastructure, Transport and Tourism of the Japanese government for its financial help. Finally, I would like to thank my parents, my brother and my friends for all of their emotional support in the completion of this thesis.

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Table of Contents Abstract

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Acknowledgment

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Introduction

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Chapter 1: Mortgage default, delinquency and personal bankruptcy

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1.1 Introduction

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1.2 Definition

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1.3 Literature review

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1.4 Determinants of borrowers’ decisions of default, delinquency and bankruptcy

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1.4.1 Dependent and explanatory variables in the SCF

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1.4.2 Probit estimations for delinquency, default and bankruptcy

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1.4.3 Ordered probit specification for delinquency and default

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1.4.4 Structural change of the impact of ARMs

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1.5 Conclusion

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Chapter 2: Delinquency choice between mortgage and nonmortgage loans

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2.1 Introduction

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2.2 Theoretical framework

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2.2.1 Delinquency, default and bankruptcy, revisited

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2.2.2 Theoretical consideration I: financial profits

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2.2.3 Theoretical consideration