Estimating a Dynamic Discrete Choice Model with Partial Observability for Household Mortgage Default and Prepayment Behaviors

Households are forward-looking when deciding whether to default on or refinance their mortgages. There are two types of default generated by two mechanisms: illiquidity-triggered default and strategic default. However, researchers can observe only whether households default but not whether the default is illiquidity-triggered or strategic. Moreover, typically researchers can observe only whether households prepay but not whether the prepayment is due to refinancing or moving. This paper extends the conditional choice probability (CCP) method to estimate a dynamic discrete choice model with partially observable outcomes. Exclusion restrictions and identification at infinity arguments provide the identification conditions. Counterfactual analyses for foreclosure-mitigating loan modification policies show that writing down the principal can reduce both illiquidity-triggered default and strategic default, that interest reduction can reduce illiquidity-triggered default but cannot effectively reduce strategic default, and that term extension can reduce illiquidity-triggered default but will increase strategic default