The Adjustable Balance Mortgage: Reducing the Value of the Put

We propose a new mortgage contract that endogenously captures the risk of house price declines to minimize default risk resulting from changes in the underlying asset value while still retaining contract rates near the cost of a standard fixed‐rate mortgage. By reducing the role of the legal system in mitigating house price risk, the new mortgage reduces the negative externalities and social costs arising from defaults. In other words, the new mortgage minimizes the need to use the legal foreclosure system to deal with the economic risk of house price declines.     

Commercial Mortgage Pricing with Unobservable Borrower Default Costs

This paper develops a pricing model for commercial real estate mortgage debt that recognizes the influence of default transaction costs on the borrower's default decision. These costs are heterogeneous across borrowers and largely un-observable to the lender/investor at the time of origination or loan purchase. A recognition of these unobservable costs can explain why borrower default decisions may differ from those predicted by "ruthless" mortgage-default pricing models. We address the determinants of default choice and timing by replacing sharp default boundaries found in the ruthless models with "fuzzy" boundaries that account for investor uncertainty with respect to evaluating borrower default decisions. To implement our model, we estimate probabilities of default as a junction of time and net equity in the property. Then, given that default occurs, loss severities are modeled based on expected property value recovery net of foreclosure costs and time until the asset is actually sold. Under reasonable parameter value choices, resulting Monte Carlo simulations produce numerical mortgage price estimates as well as component default frequency and severity levels that realistically reflect default premiums and loss levels observed in the marketplace.     

Do Riskier Borrowers Borrow More?

Conventional wisdom in the mortgage industry holds that loan-to-value (LTV) ratios are positively correlated with mortgage default rates. However, not all empirical studies of mortgage loan performance support this view. This paper offers a theoretical signaling model of why the correlation between LTV ratios and default risk is contingent upon the default costs of the borrower. Specifically, the model proposes that when default costs are high there exists a separating equilibrium in which risky borrowers will self-select into lower LTV loans to reduce the probability of facing a costly default, while safe borrowers will self-select into higher LTV loans as a signal of their enhanced creditworthiness. This adverse selection process gives rise to the possibility of higher default probabilities for lower LTV loans. Conversely, when default costs are low the conventional result, in which risky borrowers select higher LTV loans than safe borrowers, is obtained. Empirical results, based on a sample of 859 single-family residential mortgage loans drawn from the portfolio of a national mortgage lender, are consistent with the separating equilibria predicted by the model.     

Modeling the Conditional Probability of Foreclosure in the Context of Single-Family Mortgage Default Resolutions

Both empirical and pricing-simulation models of mortgage default focus on foreclosure in a one-step decision framework. Such models are misspecified to the extent that mortgage default and foreclosure are two separate decisions or events, where foreclosure is but one outcome of a default episode. This study examines the dynamics of mortgage borrower default episodes using a large sample of FHA-insured single-family mortgages. We estimate the influence of borrower characteristics, mortgage terms, and economic conditions on probabilities of various resolutions, highlighting under what conditions foreclosure is more likely to result from mortgage default.     

The Subprime Virus

We examine the correlation between prime mortgage default risk and the introduction of subprime mortgages in a local area. We motivate our analysis with a model of a default contagion effect that spreads the effect of a mortgage foreclosure from one property to surrounding properties. Through numerical analysis, we demonstrate the effect of subprime mortgage originations to the risk of prime mortgages. Finally, we offer empirical support for our model by examining the spatial variation in MSA prime mortgage default rates and the level of subprime mortgage activity.     

Unobservable Risks in Mortgage Contract Choice

This study proposes a lifetime utility maximization model where borrowers choose optimal mortgage bundles including mortgage type, loan‐to‐value and loan size to maximize their allocation of limited budgets between housing and nonhousing consumptions. The model predicts that the mortgage bundle choices by borrowers of different income and risk attributes explain significant variations in the ex post default risks of the borrowers. The empirical tests using sampled mortgages pooled in nonagency residential mortgage backed securities support the hypothesis that the optimal choice of mortgage bundles reveals hidden risk factors of borrowers, which, if ignored, could lead to misjudgment of ex post default of borrowers.     

Predicting Commercial Mortgage Foreclosure Experience

This study has two objectives: (1) it directly evaluates the relationship between commercial mortgage default incidence and characteristics of the mortgage, borrower, property, market, and general economic conditions, and (2) it uses this relationship to predict the exposure of life insurers to future mortgage defaults and to examine the relative importance of various causes of current and past credit quality problems. A theoretical model of the default decision predicts that the decision would be expected to be driven primarily by the borrower's current equity stake in the property, or the ratio of the market value of the loan to property value (M_t/V_t), but that the presence and magnitude of transaction costs associated with default would be expected to result in underexercise of the default option. Empirical estimation making use of American Council of Life Insurance (ACLI) and National Council of Real Estate Investment Fiduciaries (NCREIF) data confirms both expectations. A high proportion of the longitudinal variation in foreclosure incidence is explained by variations in M_t/V_t, but even at high ratios M_t/V_t in excess of 1.1. only 5% to 8% of mortgagors default, although this magnitude of underexercise is probably overstated because of problems in measuring M^t and for other reasons. Simulations using the model provide a pessimistic outlook for future defaults. Default rates are predicted to double in the five-year period 1988–93. Other simulations examine the relative importance of interest rate fluctuations, property value declines, and geographic or temporal correlations in lending during the 1976–88 period on current default experience.     

Reverse Mortgages: Contracting and Crossover Risk

A pricing model is developed for a reverse mortgage contract where the borrower receives payments either as a lump sum or in an annuity while the loan balance accumulates as a claim against the house. No underwriting criteria on income are applied. One risk of default is that the borrower will remain in the house after the negatively amortizing loan balance exceeds the value of the house. An explicit pricing model of the reverse mortgage permits the evaluation of this default "crossover" option. Alternative methods involving life insurance contracts and securitization are compared as secondary market channels.     

Mortgage Lending, Sample Selection and Default

Traditional models of mortgage default suffer from sample-selection bias because they do not control for the loan approval process. This paper estimates a sample-selection-corrected default model using the 1990 Boston Federal Reserve loan application sample and the 1992 Federal Housing Authority (FHA) foreclosure sample. A single-equation FHA default model appears to suffer from substantial selection bias, but the bias primarily arises from the omission of credit history and other variables that are only in the application sample. Therefore, default models that contain detailed information on applicants may not suffer from substantial selection bias. Finally, a test for prejudice-based discrimination is developed and conducted, but the findings are inconclusive.     

The Impact of Second Loans on Subprime Mortgage Defaults

An estimated 12.6% of primary mortgage loans were simultaneously originated with a second loan from 2004 until 2008, although relatively little is known about how the presence of such subordinate loans affects the default decisions of borrowers. We use a novel data series of loan servicing records from 2002 until 2010 to identify such borrowers and find evidence that the default behavior of these borrowers significantly differs from borrowers without second loans. Estimating a discrete‐time proportional odds hazard model, we find borrowers with a second loan were 62.7% more likely to default each month on their primary loan when conditioning alone on the attributes of the primary loan. However, borrowers of second loans were 58.3% less likely to default on their primary loan as compared to single‐loan borrowers with equivalent current combined attributes (i.e., loan‐to‐value, balance and interest rate). We hypothesize and provide empirical evidence that this occurs because borrowers with second loans have the option to sequentially default on each loan since subordinate lenders will not pursue foreclosure if borrowers have insufficient equity. Lenders of defaulted subordinate debt may revisit their decision to foreclose in the future after housing markets start to recover, thus prompting a new round of foreclosures.     

Equity Dilution: An Alternative Perspective on Mortgage Default

Empirical research on mortgage default in the single-family market has focused on the value of the borrower's put option using house price indices to estimate contemporaneous loan-to-value ratio or the probability of negative equity. But since the borrower possesses the option to increase leverage by taking on additional debt secured by junior liens subsequent to loan origination (a phenomenon termed here equity dilution ), even a perfect house price adjustment cannot be expected to accurately measure changes in borrower equity over time. Since junior liens are generally unobservable to senior debt holders, proxies are required in empirical applications. This paper employs an independent estimate of junior lien probability developed from the 1998 Survey of Consumer Finances combined with loan level mortgage performance data to examine the role junior liens play in increasing default risk.     

The Effect of Mortgage Payment Reduction on Default: Evidence from the Home Affordable Refinance Program

This article evaluates the effect of payment reduction on mortgage default within the context of the Home Affordable Refinance Program. We find that mortgage default is sensitive to payment reduction using univariate, duration and hazard modeling approaches. A relative risk Cox model of default with time‐varying covariates estimates that a 10% reduction in mortgage payment is associated with about a 10–11% reduction in monthly default hazard for loans. This finding is robust to the inclusion of empirically important mortgage risk drivers (such as current loan‐to‐value and FICO score) as well as controlling for selection effects based on observables.     

Thy Neighbor’s Mortgage: Does Living in a Subprime Neighborhood Affect One’s Probability of Default?

This article focuses on the potential externalities associated with subprime mortgage origination activity. Specifically, we examine whether negative spillover effects from subprime mortgage originations result in higher default rates in the surrounding area. Our empirical analysis controls for loan characteristics, house price changes and alternative loan products. Our results indicate that, after controlling for these characteristics, the concentration of subprime lending in a neighborhood does not lead to greater default risks for surrounding borrowers. However, we do find that more aggressive mortgage products (such as hybrid adjustable rate mortgages and low/no‐documentation loans) had significant negative spillovers on other borrowers. Stated differently, the aggressive alternative mortgage designs were more toxic to the housing and mortgage market than previously believed.     

Determinants of Multifamily Mortgage Default

Option–based models of mortgage default posit that the central measure of default risk is the loan–to–value (LTV) ratio. We argue, however, that an unrecognized problem with extending the basic option model to existing multifamily and commercial mortgages is that key variables in the option model are endogenous to the loan origination and property sale process. This endogeneity implies, among other things, that no empirical relationship may be observed between default and LTV. Since lenders may require lower LTVs in order to mitigate risk, mortgages with low and moderate LTVs may be as likely to default as those with high LTVs. Mindful of this risk endogeneity and its empirical implications, we examine the default experience of 495 fixed–rate multifamily mortgage loans securitized by the Resolution Trust Corporation (RTC) and the Federal Deposit Insurance Corporation (FDIC) during the period 1991–1996. The extensive nature of the data supports multivariate analysis of default incidence in a number of respects not possible in previous studies. Consistent with our expectations, we find that LTV evidences no relationship to default incidence, while the strongest predictors of default are property characteristics, including three–digit ZIP code location and initial cash flow as reflected in the debt coverage ratio. The latter results are particularly interesting in that they dominated the influence of postorigination changes in the local economy.     

The Effects of Securitization on Consumer Mortgage Costs

We examine the effects of securitization on two dimensions of consumer mortgage costs: coupon rates and loan origination fees. We find no evidence that securitization reduces the coupon rates on fixed- or adjustable-rate mortgages. Instead, securitization appears to lower mortgage loan origination fees, resulting in substantial savings for consumers. Securitization activity includes passthrough creation and collateralized mortgage obligation (CMO) creation. We test for differences between the effects of passthrough and CMO creation on primary mortgage costs. Surprisingly, these activities appear to have indistinguishable effects on loan rates and origination fees, suggesting that a large derivatives market for mortgage loans is not creating value for consumers.     

Lenders’ pricing strategy: Do neighborhood risks matter?

This article explores the different pricing strategies of lenders who originate both government-sponsored enterprise (GSE) and non-GSE loans. We find that conditional on loan and borrower characteristics and some observable local economic factors, mortgage rates on GSE loans vary significantly across regions. However, we observe no sizable regional variation in loan amounts or default risk. By contrast, the mortgage rates on non-GSE loans depend almost entirely on borrowers and loan characteristics. In addition, we find that spatial variations in GSE mortgage rates are highly responsive to regional prepayment risk. Our results are robust to various controls for neighborhood characteristics, including regional-level bank competition, borrower accessibility to mortgages, and household income levels. Overall, the findings offer a novel insight into how lenders adjust pricing strategies in response to a changing lending environment. The results provide implications relating to the present and imminent dangers of housing bubbles and the intensified refinancing wave following the COVID-19 pandemic.     

Renegotiation of Troubled Debt: The Choice between Discounted Payoff and Maturity Extension

Renegotiation of securitized debt contracts is generally a more efficient solution to default than foreclosure when there are significant deadweight costs associated with the enforcement of security rights. Recent literature shows that when renegotiation takes the form of discounted loan payoffs, it eliminates deadweight costs associated with the liquidation or transfer of assets. There is evidence, however, that, in practice, renegotiation of other contract terms such as maturity is a more common form of loan workout. This observation is puzzling because, in general, maturity renegotiation does not eliminate deadweight costs. We provide a partial answer to this puzzle by showing that maturity renegotiation better aligns the incentives of borrowers and lenders than does renegotiation of principal. Specifically, we find that borrowers who expect that lenders will renegotiate maturity in the event of default have less incentive to divert cash flow from the collateral during the term of the loan and less incentive to take on additional risk. If the lender's cost of managing these standard agency problems is positively related to the magnitude of the borrower's incentive, then maturity renegotiation will result in lower monitoring and enforcement costs.     

Contemporaneous Loan Stress and Termination Risk in the CMBS Pool: How “Ruthless” is Default?

This study analyzes the impact of contemporaneous loan stress on the termination of loans in the commercial mortgage‐backed securities pool from 1992 to 2004 using a novel measure, based on changes in net operating incomes and property values at the metropolitan statistical area‐property‐type‐year level. Employing a semi‐parametric competing risks model for a variety of specifications, we find that the probability of default is extremely low even at very high levels of stress, although the coefficient estimates of greatest interest are very statistically significant. These results suggest substantial lender forbearance and are consistent with previous research that models default as a “gradual dynamic process” rather than a “ruthless” exercise once “in the money.”     

The Cost of Foreclosure Delay

We measure the cost of foreclosure delay by estimating time‐related foreclosure costs using a large national sample of residential mortgages before, during, and after the recent U.S. housing crisis. The large volume of foreclosures, coupled with an unprecedented series of government interventions in mortgage servicing practices, significantly extended foreclosure timelines during and after the crisis.  Costs were especially pronounced in judicial review states, which saw average foreclosure costs go up 15 percentage points, 24 percentage points in the highest cost state.  Cost increases of this magnitude are likely to have consequences for servicing practices and mortgage credit availability.     

Prepayment Penalty as a Screening Mechanism for Default and Prepayment Risks

The objective of this article is to offer a theoretical model of asymmetric information to analyze the screening role of prepayment penalty. We consider both default risk and prepayment risk. What makes the role of prepayment penalty interesting and more complicated is that a borrower's contract choice could send conflicting signals to the lender about that borrower's default and prepayment risk type. This is different from earlier theoretical models of mortgage choice under asymmetric information where a certain aspect of the contract (e.g., discount points or loan‐to‐value ratio) is explored as a screening mechanism for a single risk dimension (default risk or prepayment risk) of the borrower type. We show the existence of separating equilibria where different default and prepayment risk types choose contracts with different combinations of prepayment penalty and interest rate. For certain parameter combinations, the model also generates a pooling equilibrium where all borrower types obtain the same contract. Our analysis could offer a partial explanation for the observation that contracts with prepayment penalties are a lot less prevalent than contracts with points.