PROBLEM: Suppose that you bought a house in Los Angeles, California in 2006Q1 and the house price was $600,000. Your LTV is 95%, so you borrow a fixed rate mortgage (FRM) of $570,000. The loan term is 30 years with interest rate 6% and monthly payments. Assuming the house price dropped 35% in Los Angeles during the period of 2006Q1 to 2009Q1.

1. What is the value of your house at the end of 2009Q1?
2. What is your loan balance at the end of 2009Q1 (36 months later)?

3. Which is the better choice from economic point of view and why?

• 1. Keep the house and continue to pay mortgage every month
  2. Default and walk away

Now suppose that you borrowed a price level adjusted mortgage (PLAM) in 2006Q1 instead of borrowing a FRM and assuming that the first loan balance adjustment will occur at the end of 2009Q1 and everything else is equal.

4. What is your adjusted loan balance at the end of 2009Q1 (36 months later)?

5. Which is the better choice from economic point of view and why?
   • Keep the house and continue to pay mortgage every month
   • Default and walk away

6. What is the implication for PLAM to the recent (2007-2010) housing crisis?