An Assessment of Basel II Procyclicality in Mortgage Portfolios

In this paper we develop a probability of default (PD) model for mortgage loans, taking advantage of the Spanish Credit Register, a comprehensive database on loan characteristics and credit quality. From that model, we calculate different types of PDs: point in time, PIT, through the cycle, TTC, average across the cycle and acyclical. Then, we compare capital requirements coming from the different Basel II approaches. We show that minimum regulatory capital under Basel II can be very sensitive to the risk measurement methodology employed. Thus, the procyclicality of regulatory capital requirements under Basel II is an open question, depending on the way internal rating systems are implemented and their output is utilised. We focus on the mortgage portfolio since it is one of the most under researched areas regarding the impact of Basel II and because it is one of the most important of banks’ portfolios.     

Systematic mistakes in the mortgage market and lack of financial sophistication

Institutions often offer a menu of contracts to consumers in an attempt to create a separating equilibrium that reveals borrower types and provides better pricing. We test the effectiveness of a specific set of contracts in the mortgage market: mortgage points. Points allow borrowers to exchange an upfront amount for a decrease in the mortgage rate. We document that, on average, points takers lose about $700. Also, points takers are less financially savvy (less educated, older), and they make mistakes on other dimensions (e.g., inefficiently refinancing their mortgages). Overall, our results show that borrowers overestimate how long they will stay with the mortgage.     

Are Short Sellers Informed? Evidence from the 2007–2008 Subprime Mortgage Crisis

This paper examines the short selling activities around financial firms’ announcements of asset write‐downs during the 2007–2008 subprime mortgage crisis. We find that short sellers accumulate short positions prior to write‐down announcements, and that stocks experience significantly negative returns around such announcements. These results suggest that the return predictability of short interests is due to short sellers’ informational advantage. Furthermore, we show that short sellers increase their positions significantly in the announcement month and keep increasing their positions afterward, suggesting the feedback effect of the disclosed write‐downs on financial firms’ existing exposures. The valuable information contained in the short interest should encourage regulators to mandate stock exchanges disclose short selling activities more frequently.     

Seasonality and size effects: The case of real-estate-related investment

This article documents that the well-known size-related seasonality effects exist in real-estate-related investments. The average return on REITs in January is higher than that in any other month during the year, and the abnormally high return in January tends to disappear for large REITs, both equity and mortgage REITs. The January effect for mortgage REITs appears to be larger than that for equity REITs. Some more puzzles emerge in this article concerning seasonality, including a reverse small firm effect in certain other months.     

GSEs,Mortgage Rates,and Secondary Market Activities

Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that securitize mortgages and issue mortgage-backed securities (MBS). In addition, the GSEs are active participants in the secondary mortgage market on behalf of their own investment portfolios. Because these portfolios have grown quite large, portfolio purchases (in addition to MBS issuance) are often thought to be an important force in the mortgage market. Using monthly data from 1993 to 2005 we estimate a VAR model of the relationship between GSE secondary market activities and mortgage interest rate spreads. We find that GSE portfolio purchases have no significant effects on either primary or secondary mortgage rate spreads. Further, we examine GSE activities and mortgage rate spreads in the wake of the 1998 debt crisis, and find that GSE portfolio purchases did little to affect mortgage rates. This empirical finding is robust to alternative identification assumptions and to alternative model and variable specifications.      

The role of credit in the Great Moderation: A multivariate GARCH approach

During the Great Moderation, financial innovation in the US increased the size and scope of credit flows supporting the growth of wealth. We hypothesize that spending out of wealth came to finance a wider range of GDP components such that it smoothed GDP. Both these trends combined would be consistent with a decrease in the volatility of output. We suggest testable implications in terms of both growth of credit and output and volatility of growth. In a multivariate GARCH framework, we test this view for home mortgages and residential investment. We observe unidirectional causality in variance from total output, residential investment and non-residential output to mortgage lending before, but not during the Great Moderation. These findings are consistent with a role for credit dynamics in explaining the Great Moderation.     

Housing Tenure and Mortgage Choice

This paper examines the relationship between housing tenure and mortgage contract. We present a model showing that, given expected mobility, borrowers will have incentive to self-select into the appropriate mortgage product such that their fixed-rate period is directly related to their probability of moving. We empirically test this hypothesis using housing tenure data derived from a large national database of repeat mortgage transactions. After controlling for borrower characteristics, the mobility hazards of 3/1, 5/1 and 7/1 ARMs, compared to a 30-year fixed rate, are estimated to be 28%, 14% and 11% higher, respectively     

The impact of CRA agreements on community banks

We develop three empirical models to identify the impact of Community Reinvestment Act (CRA) agreements on the mortgage lending behavior of small banking institutions during the period 1990–1997. CRA agreements are pledges banking institutions make to extend levels of credit to targeted populations and are often used by institutions to reaffirm their commitment to the goals of the CRA. We hypothesize that CRA agreements increase the level of competition for mortgage loans in the targeted area, which in turn causes a reduction in the quantity of mortgage credit to be supplied by community banks. Consistent with the quantity hypothesis, the results show that CRA agreements are associated with less mortgage lending, including lending in lower-income communities (CRA lending) and in minority communities (minority lending), by small community lenders. Evidence does not support a second hypothesis – that community banks respond to the increased competition by providing credit to riskier individuals.     

Inferring Price Information from Mortgage Payment Behavior: a Latent Index Approach

Existing price indices are based on real estate sales. This approach encounters problems when (1) sales are infrequent or (2) when these differ systematically from the overall market (selection bias). Relative to the number of properties sold on the market, a much greater number of properties have borrowers who need to make monthly mortgage payment decisions. Therefore, each month borrowers cast a vote of confidence or no confidence in their price relative to the loan balance. Based on this behavior, we invert the relation between mortgage performance and prices to derive a latent price index. Using a large sample of individual mortgages across the 10 cities investigated, the latent index in each city has a high correlation with the respective Case-Shiller index. In addition, the latent index is partially explained by the housing expectations (derived from futures on the respective Case-Shiller index) which indicates that it is not a purely reactive measure. Overall the results show that the latent index has potential to boost information resources for tracking the important real estate sector.     

Economic Consequences of Transparency Regulation: Evidence from Bank Mortgage Lending

We examine the economic consequences of a rule designed to improve consumers' understanding of mortgage information. The 2015 TILA-RESPA Integrated Disclosures rule (TRID) simplifies the mortgage disclosures provided to consumers. As a consequence, TRID-affected mortgages become a less attractive investment opportunity to banks. Our main results document that mortgage applications affected by TRID are less likely to be approved following the rule's effective date. We find evidence consistent with both a decrease in consumers' information processing costs and an increase in banks' secondary market frictions, providing insight into the potential channels through which this reduction in mortgage credit operates. We also find that banks partially compensate for reduced mortgage lending by increasing small business lending, and that fintechs absorb mortgage demand in areas with reduced mortgage lending by banks. Our study documents real actions that firms take in response to disclosure transparency regulation and contributes to the literature on the economic consequences of such regulation.     

Housing and Tax Policy

This paper investigates the effects of housing‐related tax policy measures on macroeconomic aggregates using a dynamic general‐equilibrium model featuring borrowing and lending across heterogeneous households, financial frictions in the form of collateral constraints tied to house prices, and a rental housing market alongside owner‐occupied housing. We analyze the effects of various tax policies and find that they all lead to significant output losses, with large long‐run tax multipliers of around 2. Among them, reducing the mortgage interest deduction is the most effective in raising tax revenue per unit of output lost, whereas reducing the depreciation allowance for rental income is the least effective.     

Predatory lending and the subprime crisis

We measure the effect of a 2006 antipredatory pilot program in Chicago on mortgage default rates to test whether predatory lending was a key element in fueling the subprime crisis. Under the program, risky borrowers or risky mortgage contracts or both triggered review sessions by housing counselors who shared their findings with the state regulator. The pilot program cut market activity in half, largely through the exit of lenders specializing in risky loans and through a decline in the share of subprime borrowers. Our results suggest that predatory lending practices contributed to high mortgage default rates among subprime borrowers, raising them by about a third.     

Mortgage Payment Problem Development and Recovery: A Joint Probability Model Approach

The existing literature on mortgage default and foreclosure largely examines the development of mortgage problems (the first stage) and the possibility of recovery from such problems (the second stage) separately. Such studies may provide an incomplete picture of the development and possible resolution of mortgage problems. This paper uses the proprietary geo-coded version of the Panel Study of Income Dynamics from 2009 through 2013 to implement a different type of probability model. Three transitional probability equations are estimated: the likelihood of homeowners developing mortgage payment problems, the likelihood that those who develop such problems move to resolve their problems, and the conditional probability that those who develop such problems and don’t move will recover from them by other means. The coefficients from all three are combined to calculate the joint (state) probability of households having mortgage problems from which they will not recover. The analysis contains a number of unique results: changes in the mortgage front-end ratio are shown to have a substantial influence on both developing a mortgage problem and its resolution for those who do not move, 2) prior foreclosures are determined to affect the development of current mortgage problems, and 3) out-of-pocket medical expenses are found to influence both mortgage problem development and recovery. Also, the impact of policy actions are considered across several at-risk demographic groups. This experiment demonstrates that by improving the financial and mortgage characteristics, and the education level of households that actually develop mortgage problems, their predicted probability of developing mortgage problems that cannot be resolved could be reduced substantially.     

Subprime Borrowers: Mortgage Transitions and Outcomes

Public policy concerns increasingly have focused on subprime lending. Our research uses a survey of prime and subprime borrowers to address whether borrowers inappropriately are channeled to the subprime segment, if once having taken out a subprime mortgage borrowers are stuck in this market segment, and whether borrowers face higher costs by taking out subprime mortgages. We find that subprime borrowers are less knowledgeable about the mortgage process, are less likely to search for the best mortgage rates, and are less likely to be offered a choice among alternative mortgage terms and instruments—possibly making them more vulnerable to unfavorable mortgage outcomes. Our analysis of market segmentation confirms that typical mortgage underwriting criteria are most important in explaining whether borrowers obtain prime or subprime mortgages—higher credit risk borrowers are more likely to get a subprime loan. Our results further show that search behavior and other demographic factors including adverse life events, age, and Hispanic ethnicity contribute to explaining market segment, suggesting that borrowers may inappropriately receive subprime mortgages. While we find some persistence to market segment—borrowers are more likely to take out a subprime mortgage if their previous mortgage came from the subprime segment—we also find that market segment is not immutable. Analysis of the survey responses indicates that borrowers with subprime mortgages significantly are more dissatisfied with their mortgage outcomes. This is not surprising because subprime borrowers look worse across typical mortgage underwriting criteria. Consistent with policy concerns, however, despite holding constant these and other factors, taking out a mortgage in the subprime segment, by itself, appears to increase dissatisfaction with mortgage outcomes. We do not provide a definitive answer to the question of whether subprime lending, on balance, serves homebuyers well by providing access to mortgage credit to those otherwise constrained, or rather serves homebuyers poorly by inappropriately assigning them to a market where costs are high and the ability to transition to more attractive prime mortgages remains low. Our analysis, however, does provide some empirical support for concerns raised by critics of subprime lending, and for this reason justifies continued public policy debate and analysis.     

A Test of Integration and Cointegration of Commercial Mortgage Rates

Little empirical work examines the extent to which commercial mortgage markets are integrated into broader capital markets. We use time series data on commercial mortgage yields and yields on comparable-maturity Treasury securities to identify a long-run cointegrating relationship between the two yield series. Our empirical evidence suggest that, while the yield on commercial mortgage is cointegrated with that on comparable-maturity Treasury securities, the cointegrating relationship is far less than that found between the yield on residential mortgage rates and that on comparable-maturity Treasury securities during 1980–1990 time period. However, our results also show that the spate of commercial mortgage securitization that began in early 1991 may have been a market-integrating force and caused the commercial mortgage market to become more integrated into broader capital markets. Indeed, our results suggest that changes in capital market rates are now much more rapidly reflected in commercial mortgage rates than in the 1980–1990 time period, although there is a lag.     

Mortgage timing

We study how the term structure of interest rates relates to mortgage choice at both household and aggregate levels. A simple utility framework of mortgage choice points to the long-term bond risk premium as distinct from the yield spread and the long yield as a theoretical determinant of mortgage choice: when the bond risk premium is high, fixed-rate mortgage payments are high, making adjustable-rate mortgages more attractive. We confirm empirically that the bulk of the time variation in both aggregate and loan-level mortgage choice can be explained by time variation in the bond risk premium, whether bond risk premia are measured using forecasters’ data, a vector autoregressive (VAR) term structure model, or a simple household decision rule based on adaptive expectations. The household decision rule moves in lock-step with mortgage choice, lending credibility to a theory of strategic mortgage timing by households.     

Mortgage risks,debt literacy and financial advice

A limited understanding of mortgage contracts and the risks involved may have contributed to the outbreak of the 2007–2008 financial crisis. We developed a special questionnaire relating mortgage loan decisions to financial knowledge and financial advice. Our results demonstrate that homeowners appear to be well aware of mortgage risks. Large loans relative to home value are perceived as riskier, as are loans with large mortgage payments relative to income and loans linked to investment vehicles. Homeowners with riskier mortgages indicated that they could encounter financial problems should house prices or their income decline. Homeowners with relatively low debt literacy are more likely to take out traditional mortgages with principal repayments over the maturity of the loan. Riskier mortgages are more prevalent among homeowners with a better understanding of loan contracts. Financially less sophisticated homeowners consulting mortgage brokers, too, hold riskier mortgages.     

Asymmetric information and price competition in small business lending

This paper examines the relationship between bank lending rates and their cost of funds in New Zealand. Our results show that on average mortgage rates respond more quickly to changes in the cost of funds than base business lending rates. We also find an asymmetry in the initial (short-run) response of banks to changes in funding costs; in particular, our results show banks adjust mortgage rates downwards faster than upwards. The speed to which lending rates revert back to their equilibrium relationship with funding costs varies across the lending markets. We find the adjustment speed is faster when mortgage rates are below equilibrium, whereas it is slower when business lending rates are above long-run levels in relation to funding costs. Our analysis suggests that banks prefer the plain-vanilla type of lending such as mortgages in comparison to small business lending consistent with asymmetric information associated with business loans.     

Infrequent Housing Adjustment,Limited Participation,and Monetary Policy

This paper asks why monetary contractions have strong effects on the housing market. The paper presents a model with staggered housing adjustment in which monetary policy has real effects in the absence of any rigidity in producer pricing or wages. Limited participation in financial markets leads to a rise in the real mortgage rate following an increase in the nominal short rate. Since households must take on a mortgage to consume housing, the rise in the real interest rate reduces the share of residential investment in output.     

An Early Assessment of Residential Mortgage Performance in China

The residential mortgage market becomes a financial engine for the booming residential housing development and sustained economic growth in China. Our study provides the first rigorous empirical analysis on the earlier performance of residential mortgage market in China based on a unique micro dataset of mortgage loan history collected from a major residential mortgage lender in China. We found that while the option theory fails to explain prepayment and default behavior in the residential mortgage market in China, other non-option theory related financial economic factors play major roles in determining the prepayment and default risks in China. We also found that borrower’s characteristics are significant in determining prepayment behavior, hence may be used as an effective tool for screening potential high risk borrowers in the loan origination process. Adopting a risk-based pricing in residential mortgage lending in China can improve the efficiency of the market, and enhance the credit availability to the most needed households, i.e., the younger households, blue-collar workers, lower income households, and help them become homeowners.