Journal of Real Estate Finance and Economics, 23:2, 213±234, 2001
# 2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
Optimal Put Exercise: An Empirical Examination of
Conditions for Mortgage Foreclosure
BRENT W. AMBROSE
Center for Real Estate Studies, University of Kentucky, Lexington, KY 40506-0034
CHARLES A. CAPONE, JR.
Congressional Budget Of®ce, Ford House Of®ce Building, Washington, DC 20515
University of Southern California, School of Policy, Planning, and Development, and Marshall School of
Business, 650 Childs Way, Los Angeles, CA 90089-0626
Implicit in option-pricing models of mortgage valuation are threshold levels of put-option value that must be
crossed to induce borrower default. There has been little research into what these threshold values are that come
out of pricing models or how they compare to exercised option values seen in empirical data. This study
decomposes boundary conditions for optimal default exercise to look at the economic dynamics that should lead
to optimal default timing. Empirical data on FHA insured mortgage foreclosures is then examined to discern the
predictive in¯uence of optimal-option-valuation-and-exercise variables on observed default timing and values.
Interesting results include a new understanding of how to measure and use property equity variables during
economic downturns, house-price index ranges over which default is exercised for various classes of borrowers,
and implied differences in appreciation rates between market-price indices and foreclosed properties.
Key Words: mortgage default, loss severity, option value
1. Introduction: Ruthlessness of default-option exercise
The contingent-claim approach to modeling mortgage default has led to a lengthy debate
over the ruthlessness of borrowers in exercising implicit put options imbedded in mortgage
contracts. Original option-pricing models described ruthless or frictionless default as
borrowers giving up property rights in exchange for release from the mortgage obligation
whenever the market value of the mortgage exceeds the value of the underlying property.
The idea of ruthless default arose from early mortgage pricing models where boundary
conditions for default were set at the point where the market value of the mortgage equaled
the property value (see Titman and Torous, 1989).
Are there signi®cant levels of transaction costs that impede frictionless option exercise,
or is the degree of nonruthlessness observed in practice a function of the value of