A Model of Mortgage Default

In this paper, we solve a dynamic model of households' mortgage decisions incorporating labor income, house price, inflation, and interest rate risk. Using a zero‐profit condition for mortgage lenders, we solve for equilibrium mortgage rates given borrower characteristics and optimal decisions. The model quantifies the effects of adjustable versus fixed mortgage rates, loan‐to‐value ratios, and mortgage affordability measures on mortgage premia and default. Mortgage selection by heterogeneous borrowers helps explain the higher default rates on adjustable‐rate mortgages during the recent U.S. housing downturn, and the variation in mortgage premia with the level of interest rates.     

Effects of Bankruptcy Exemptions and Foreclosure Laws on Mortgage Default and Foreclosure Rates

This study analyzes the effects of state bankruptcy asset exemptions and foreclosure laws on mortgage default and foreclosure rates across different segments of the mortgage market. We found that the effects of these legal provisions are larger for subprime than for prime mortgages and larger for adjustable rate mortgages than for fixed rate mortgages. These results demonstrate that the effect of variation in bankruptcy exemptions and foreclosure laws is most pronounced in the most risky segments of the mortgage market, which are those that have been most affected by the continuing housing slump in the United States.     

Housing,mortgage bailout guarantees and the macro economy

What are the macroeconomic and distributional effects of government bailout guarantees for Government Sponsored Enterprises (e.g., Fannie Mae)? A model with heterogeneous, infinitely lived households and competitive housing and mortgage markets is constructed to evaluate this question. Households can default on their mortgages via foreclosure. The bailout guarantee is a tax-financed mortgage interest rate subsidy. Eliminating this subsidy leads to a large decline in mortgage origination and increases aggregate welfare by 0.5% in consumption equivalent variation, but has little effect on foreclosure rates and housing investment. The interest rate subsidy is a regressive policy: it hurts low-income and low-asset households.     

Mortgage Choice in the Euro Area: Macroeconomic Determinants and the Effect of Monetary Policy on Debt Burdens

This paper provides novel evidence on the role of the macroeconomic environment for households’ choice between fixed‐interest‐rate and adjustable‐interest‐rate mortgages (ARMs) in the euro area. We find that relatively more ARMs are taken out when economic growth is strong, the interest rate spread is high, or unemployment shows low volatility. A simulation exercise shows that a reduction in mortgage rates as witnessed during the monetary easing in the course of the global financial crisis produces a substantial decline in debt burdens among mortgage‐holding households, especially in countries where households have higher debt burdens and a larger share of ARMs.     

Joint Dynamics of House Prices and Foreclosures

This paper studies the joint transitional dynamics of the foreclosures and house prices in a standard life‐cycle incomplete markets model with housing and a realistic long‐term mortgage structure. We calibrate our model to match several long‐term features of the U.S. housing market, and analyze the effects of several unexpected and permanent shocks on the house price and the foreclosure rate both across the steady states and along the transition between the steady states. We examine permanent, unexpected shocks to the risk‐free interest rate, the minimum down‐payment ratio, and unemployment. During the transition, these shocks create large movements in house prices. More importantly, the foreclosure dynamics are quite significant along the transition compared to the steady‐state changes, and there are strong feedbacks between foreclosures and house prices. We assess the effects of a temporary reduction in the risk‐free interest rate, which has moderate effects on house prices but little effect on foreclosure dynamics. We also study the effects of an ex ante macroprudential policy, which establishes a minimum down‐payment requirement at a higher threshold. Such a macroprudential policy helps substantially stabilize both house prices and foreclosures.     

Interest rate risk and optimal design of mortgage instruments

This article develops and analyzes a simple expected utility model for interest rate risk and mortgage choice. The model demonstrates how the risks of interest rate changes should be allocated between borrowers and lenders through varying mortgage payments. In general, we conclude that full protection against interest rate risk, as a normative guideline, is likely to be suboptimal for the typical household. Our results show that the optimal design of adjustable rate mortgages should include an interest rate CAP provision.An earlier version of this article was presented at the American Real Estate and Urban Economics Association Meetings, Atlanta, Georgia, December 27–30, 1989.     

A Neural Network Analysis of Mortgage Choice

There exists today an unanswered question as to whether, and the degree to which, borrower characteristics impact the choice between fixed and adjustable rate mortgages. In this paper, we apply a neural network analysis to supply evidence that answers this question. We find evidence that the characteristics of a borrower's net worth, marital status and education level and whether a co-borrower is involved contribute in a significant way to the neural network's ability to determine mortgage choice. Further, we show how, because of the facility of neural networks in modeling intrasample differences, they achieve material and statistically significant accuracy gains over qualitative choice models in predicting whether a borrower will choose a fixed or adjustable rate mortgage.     

Fixed‐Rate Mortgages,Labor Markets,and Efficiency

The paper studies the effects of mortgage choices between fixed‐rate mortgages (FRMs) and adjustable‐rate mortgages (ARMs) on labor market efficiency. FRMs provide insurance for risk‐averse borrowers in the sense that they pay the same rate over time and are not subject to uncertain spot market rates. FRMs, however, discourage borrowers from moving to other regions despite better employment opportunities, as they terminate the FRM contracts in order to move and their new loan interests may be higher. As FRM‐borrowers do not move to other regions due to the interest lock‐ins, entrepreneurs in other regions lose the potential surpluses from productive matches that would have occurred between borrowers‐workers and entrepreneurs. Borrowers ignore this negative externality they impose on the entrepreneurs when choosing their mortgages, and too many borrowers choose FRMs relative to the efficient level. If FRMs are eliminated and ARM‐insurance (that protects ARM‐borrowers against uncertain adjustable interest rates) is created, it will improve efficiency. The paper also assesses quantitatively the welfare effects of eliminating FRMs and providing ARM‐insurance.     

Testing for Fraud in the Residential Mortgage Market: How Much Did Early-Payment-Defaults Overpay for Housing?

Current explanations for the high rate of default and foreclosure in the U.S. emphasize house price fluctuations and lax lending criteria. Another explanation for default and foreclosure, which has generally been neglected in the academic literature but not by the FBI, is fraud. One impediment to identifying and measuring fraud is the lack of statistical tests capable of detecting it. This paper proposes a simple method to detect transactions where fraud may have occurred. The models proposed here are important for at least three reasons. First they can document the role of fraud in the mortgage foreclosure crisis. Second, they can serve as part of a forensic effort designed to detect and deter mortgage fraud. Third, they demonstrate that mortgage fraud distorts house price indexes because it artificially elevates house prices during the period of fraud followed by a subsequent collapse due to the foreclosure sales. Accordingly, fraud can give the false impression that foreclosure lowers area house prices when it actually artificially inflates them. This suggests an alternative interpretation for the recent empirical literature on externalities from foreclosure.     

State Foreclosure Laws and Mortgage Origination in the Subprime

Foreclosure procedures in some states are considerably swifter and less costly for lenders than in others. In light of the foreclosure crisis, an empirical understanding of the effect of foreclosure procedures on the mortgage market is critical. This study finds that lender-favorable foreclosure procedures are associated with more lending activity in the subprime market. The study uses hand-coded state foreclosure law variables to construct a numerical index measuring the favorability of state foreclosure laws to lenders. Mortgage origination data from state-border areas shows that lender-friendly foreclosure is associated with an increase in subprime originations, but has less effect on the prime market.     

Securitization and optimal foreclosure

Does securitization distort the foreclosure decisions of non-performing mortgages? In a model of mortgage-backed securitization with an endogenous foreclosure policy, we find that the securitizing bank adopts a tougher foreclosure policy than the first-best, despite resulting in higher loan losses. This is optimal because foreclosure mitigates the adverse selection problem in securitization by making the optimal security, a risky debt, less information-sensitive. We further show that policies that limit mortgage foreclosure would discourage the bank’s ex ante screening effort, reducing the quality of securitized mortgages. Our model yields novel testable predictions on the effect of mortgage securitization on foreclosure rates, loan performance, and mortgage servicing.     

Renegotiation in the Common Law Mortgage and the Impact of Equitable Redemption

This paper seeks to fill a gap in the real estate finance literature by linking the well-known history of the Anglo–American mortgage recorded by legal scholars with the recent literature on security design and incomplete contracting in order to explain and evaluate several unique features of the mortgage. In particular, we investigate how a conditional transfer of ownership to a lender and the institution called the equity of redemption affect mortgage renegotiation and therefore the value of mortgaged real estate. Given the governance of the common law mortgage, we show that a mortgagor may not be able to renegotiate his mortgage debt in order delay repayment when faced with a re-investment opportunity during the life of the mortgage. The failure to optimally renegotiate the mortgage does not necessarily result in foreclosure but may result in underinvestment. Therefore, an additional period of time between default and foreclosure, known as a period of equitable redemption, may allow the mortgagor to accrue sufficient cash flow to not only avoid foreclosure but to mitigate underinvestment in non-default states. Since this extra period of time may not be achievable ex post due to a hold-up problem, its inclusion ex ante may be welfare improving.     

The Influence of Foreclosure Delays on Borrowers' Default Behavior

This paper conducts loan‐level analysis to investigate the influence of expected foreclosure delay on a borrower's default propensity. We include the actual foreclosure times in the analysis to capture the dynamic nature of foreclosure duration. Consistent with theoretical predictions, we find a statistically and economically significant impact of foreclosure delay on borrower default behavior. In the current market condition where many borrowers have negative equity, the increase in delay may make default an optimal choice for more borrowers. The negative effect of increased foreclosure delay may need to be considered when devising policies to aid troubled borrowers.     

The economic role of foreclosures

We consider the economic consequences of changing the foreclosure rules. By incorporating renegotiation into the analysis, we show that although renegotiation decreases the number of foreclosures it can make the effects of foreclosure more significant. Even when foreclosure does not actually occur, a change in foreclosure rules changes the threat points of lender and borrower in any renegotiation, and thus changes the effective interest rate that the lender receives. In the long run, stated interest rates on loans will adjust to compensate for any change in the effective interest rate. We also examine the impact of a change in foreclosure laws on the borrower's welfare.     

Wimp or tough guy: Sequential default risk and signaling with mortgages

When analyzing what to do with a currently defaulted loan, the lender must consider the impact of his foreclosure versus workout decision on the expected payoff of subsequent loans as well as on the payoff of the current loan. This is because borrowers with future loan payoff dates can observe the lender's actions and update prior information regarding the lender's toughness or wimpiness when dealing with defaulted loans. In this paper we consider the strategic interaction between a lender and multiple borrowers, where borrowers have distinct, sequentially maturing mortgage loans and where the lender has private information regarding the magnitude of his foreclosure costs. We find that a variety of strategic outcomes can occur that explain the co-existence of workout and foreclosure in the mortgage marketplace. In general, the lender's workout/foreclosure response depends on the cost of bluffing (e.g., foreclosing when workout is cheaper) versus the value of reducing expected defaults and workout concession losses on future loans (e.g., imperfect foreclosure cost information leads future borrowers to payoff the mortgage when default would have been optimal under perfect information). Given recently revised expectations regarding the depth of the real estate recession, our results may explain the move by many lenders away from granting workout concessions and toward taking a harder line when dealing with defaulting borrowers.     

Strategic default,workout, and commercial mortgage valuation

This paper extends existing equilibrium commercial mortgage pricing models by endogenizing negotiated workout into the usual noncooperative lending game. Workout is a feasible subgame strategy for the lender to play whenever foreclosure transaction costs exist for either party to a loan transaction. In particular, negotiated workout solutions Pareto dominate the foreclosure alternative when default occurs. To obtain our results, we embed a cooperative bargaining game within a noncooperative mortgage loan/default game. We also address the valuation wedge problem that occurs when foreclosure transaction costs are introduced. Through the notion of replacement game equilibrium, we find symmetric mortgage pricing solutions that eliminate the valuation wedge and thus suggest that lending will occur in commercial real estate mortgage markets even when foreclosure transaction costs exist.     

Does Fair Value Accounting Exacerbate the Procyclicality of Bank Lending?

This study investigates whether fair value accounting contributes to the procyclicality of bank lending. Using banks’ approval/denial decisions on residential mortgage applications to capture banks’ supply of credit, I find no evidence that fair value accounting has procyclical effects on bank lending over the past two business cycles. I further identify two reasons for this result. First, the main accounting item distinguishing fair value accounting from historical cost accounting—unrealized gains and losses on available‐for‐sale securities—does not affect lending decisions. Second, unrealized gains and losses on available‐for‐sale securities are not procyclical, as the risk‐free interest rate rises during some expansionary periods, resulting in unrealized losses, while the risk‐free interest rate (and sometimes the default spread) falls during some recessionary periods, resulting in unrealized gains.     

Banking advice on fixed or adjustable mortgage rates

Since the mid-1990s, Sweden has experienced a period of rapidly rising property prices, and household indebtedness has kept an even pace. The choice between fixed and adjustable interest rates has become increasingly important. This article analyses mortgage rate advice issued by a bank adviser in monthly newsletters during the period 2001–2009, focusing on the content and searching for patterns that may be related to earlier findings. The banking advice is classified into two dimensions: the content and the strength of advice. We find that a large part of the advice suggests that borrowers divide their loans and choose both adjustable and fixed interest rates. Contrary to existing literature, there is no apparent association between the advice provided and interest rate trends (neither short- nor long-term trends). Nor do we find a significant association between the advice and the interest rate gap between fixed and variable rates. This finding implies that the advice in these newsletters was formulated on a rather unclear basis and was of limited use for borrowers.     

Mortgage Design in an Equilibrium Model of the Housing Market

How can mortgages be redesigned to reduce macrovolatility and default? We address this question using a quantitative equilibrium life‐cycle model. Designs with countercyclical payments outperform fixed payments. Among those, designs that front‐load payment reductions in recessions outperform those that spread relief over the full term. Front‐loading alleviates liquidity constraints when they bind most, reducing default and stimulating housing demand. To illustrate, a fixed‐rate mortgage (FRM) with an option to convert to adjustable‐rate mortgage, which front‐loads payment reductions relative to an FRM with an option to refinance underwater, reduces price and consumption declines six times as much and default three times as much.     

Private information and incentives: Implications for mortgage contract terms and pricing

We examine the linkage in equilibrium among (1) contract design; (2) expected prepayment and default likelihoods; and (3) the pricing of mortgage contracts by focusing upon the effects of the borrower's private information at the time of contracting. We examine the implications of these perspectives upon the empirical analysis of prepayment behavior and use the framework to examine the predominance of long-term mortgage contracts in the United States. We consider examples that explore the trade-offs between fixed and adjustable rate instruments, assumable and due-on-sale loans, and contract interest rates and initial discounts (points).