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 solutionsin the long contract maturity limit .
We analyze recently proposed mortgage contracts that aim to eliminate selective borrower default when the loan balance exceeds the house price (the ``underwater'' effect). We show contracts that 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. We obtain these results for perpetual versions of the contracts using American options pricing methodology , in a continuous-time model with diffusive home prices. The contracts' values and optimal decision rules are associated with free boundary problems , which admit semi-explicit solutions .
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