Embedded Options in the Mortgage Contract

Loss mitigation is the process by which lenders attempt to minimize losses associated with foreclosure. As competition increases in the mortgage industry, lenders and servicers are under great pressure to adopt loss mitigation tactics rather than simply use foreclosure as the means of dealing with borrowers in default. This study presents a mortgage-pricing model that fully specifies all borrower options with respect to default, including the ability to reinstate the mortgage out of default. We document the impact of various loss mitigation programs, including forbearance and antideficiency judgments, as well as the value of credit on borrower default behavior.     

Are Commercial Mortgage Defaults Affected by Tax Considerations?

We study whether tax considerations are an important determinant of commercial mortgage default. We also study whether large lenders are better informed, or better at interpreting information for lending purposes, and hence have lower foreclosure rates; whether lenders have more information on larger borrowers than smaller borrowers, and hence have lower foreclosure rates on larger loans; and whether commercial mortgage defaults are related to debt service coverage and loan-to-values, both initial and contemporaneous. The paper’s main findings are fourfold. First, holding all else equal, there is evidence that tax considerations influence investors’ decisions about when to “put” assets to lenders. The results are consistent with the argument of Constantinides (J Financ Econ 13:65–89, 1984). Second, the evidence suggests that large lenders are especially knowledgeable about commercial mortgage borrowers and commercial property markets, in that they have lower foreclosure rates than smaller lenders. Third, on the question of whether lenders have more information on larger borrowers than smaller borrowers, we find that larger loans have, on average, lower default rates than smaller loans. Fourth, the findings suggest that lower default rates are associated with higher debt service coverage ratios, both initial and contemporaneous.     

The effect of foreclosure laws on securitization: Evidence from U.S. states

A mortgage that defaults is more likely to enter foreclosure rather than renegotiation if it has been securitized in the private non-agency market, according to previous research. We study whether this foreclosure-propensity affects lenders’ securitization decision ex-ante. Due to the higher foreclosure probability, the value of a mortgage should be more sensitive to foreclosure costs if it is securitized. Comparing loans made in the same metropolitan area but under different foreclosure laws, we find that lenders are less likely to securitize mortgages in states with higher foreclosure costs, as measured by laws requiring judicial foreclosure. Two additional results are consistent with the proposed channel. First, the effect increases for loans with higher expected default rates and disappears for mortgage-like loans not subject to these laws. Second, the effect of judicial requirements increases for loans with higher expected default rates, consistent with differences in loss given default driving the results. Borrowers in states without judicial requirements also get riskier loans.     

Contract theory and mortgage foreclosure moratoria

Contracts are an essential institution in capitalist economies. Contract law provides a long and interesting constitutional history. At the same time, mortgage foreclosure moratoria is shown to be an occasional and repeated phenomenon. This paper explores the legal and economic aspects of this issue via a survey of the schools of thought on contracts. The paper also speculates about the nature of mortgage contracts and the economics of moratoria statutes.     

Impact of Foreclosure Laws on Mortgage Loan Supply and Performance

The Journal of Real Estate Finance and Economics - This paper measures the impact of three types of defaulter-friendly foreclosure laws on the behaviors of mortgage lenders in loan origination, and...     

Government intervention in the mortgage market: A study of anti-redlining regulations

This paper addresses the question of whether economic incentives exist for mortgage lenders to avoid or to minimize mortgage originations in neighborhoods inhabited primarily by low-income racial minorities. The Option Pricing Model is utilized to determine what mortgage borrower characteristics affect the market value of the mortgage contracts. It is found that existing laws do not enable mortgage lenders to vary either origination prices or mortgage terms so as to adjust for differences in the market values of mortgages. As a result, incentives are created for both the mortgage lender and the mortgage insurer to avoid originations and underwritings in areas with relatively high default probabilities. Various changes in mortgage lending regulations are suggested to eliminate these incentives, and the effects of alternative programs to subsidize mortgage borrowers with relatively high default probabilities are considered.     

Subprime Transitions: Lingering or Malingering in Default?

When a mortgage borrower becomes seriously delinquent (i.e., defaults), the lender initiates a time consuming and complex recovery process that may or may not result in foreclosure and eventual disposition of the real estate collateral (REO). This research studies this transition process for a unique sample of subprime mortgages that were seriously delinquent on September 30, 2001. Eight months later, possible states for the delinquent loans, in order, are 1)to remain delinquent without deteriorating further, 2) foreclosure, 3) worsen, i.e., become more months delinquent, 4) bankruptcy and 5) cure. The data indicate that, relative to prime loans, when subprime loans become seriously delinquent (90 days or longer) they are about twice as likely to become REO but take about four times longer to get there. It is unusual for a subprime default to be cured suggesting considerable forbearance by subprime lenders. We explore determinants of the transition probabilities and find that the most economically important predictors of transition from default to any other state are the number of payments the borrower has made and the loan to value ratio.     

The Hazard Rates of First and Second Defaults

This article examines hazards of repeated mortgage default, conditional on reinstating out of an initial default episode. Results indicate that subsequent default risk for reinstated borrowers is significantly greater than the risk of first default, especially during the first two years after a default episode. In addition, economic factors helpful in predicting first defaults are not helpful in predicting subsequent default episodes. This has important implications for mortgage investors and servicers as industry foreclosure avoidance efforts intensify.     

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.     

Performance of residential mortgages in low and moderate-income neighborhoods

This paper presents the first data on performance of mortgages on residences located in lowand moderate-income neighborhoods of U.S. cities. It provides new data on delinquencies and foreclosure provided by a sample of lenders who are members of the National Association of Affordable Housing Lenders and who have lending programs established pursuant to the Community Reinvestment Act.Sample mortgages on multifamily dwellings perform comparably with national sample data, whereas sample mortgages on single-family mortgages perform much better than comparable national sample data.The findings of this paper demonstrate clearly that lending programs in lowand moderate-income neighborhoods can be viable. The findings do not, however, help to settle the issue as the racial or gender discrimination in mortgage origination.This paper is based on Performance Analysis of Community Reinvestment Programs, prepared by the athors for the Woodstock Institute, Chicago, IL.     

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.     

Evaluating Real Estate Valuation Systems

A framework for comparing real estate valuation systems (including automated valuation models (AVMs) and current appraisal methods) is proposed. The density estimation and profit simulation (DEPS) method measures quality of a valuation system by simulating benefits to the mortgage lender who uses this method in mortgage underwriting to limit mortgage portfolio losses due to default. Related simple measures relevant to the selection of a valuation system are also discussed: skewness of the distribution of errors, correlation of valuation errors with current selling price errors, correlation of errors of the valuation system with errors of valuation systems used by competing mortgage lenders, and other measures.     

Resolution of incentive conflicts in the mortgage industry

This paper analyzes the contractual response to incentive divergencies in the housing-finance sector of the economy. Emphasis is placed on the role played by the private mortgage insurance master policy in stemming the moral hazard of lenders. The structure of the coinsurance feature of the policy is shown to induce the lender to lessen foreclosure costs. Cases are identified where the inducements of coinsurance are not complete. This incompleteness explains the role of the time constraints and bidding instructions imposed on the lender by the master policy.The paper also considers the effects that securitization is having on the incentives of the players in housing finance. The decoupling of the lender from the investor role is lessening the effectiveness of coinsurance, thereby creating new agency costs. Responses such as increased explicit monitoring and the use of reputational bonding are noted and the expected future direction of the contractual structure is discussed.     

Loss Recoveries,Realized Excess Returns,and Credit Rationing in the Commercial Mortgage Market

In this paper we exploit loan level data combining foreclosure histories with information about the revenues and expenses associated with the ongoing management and eventual sale of financially distressed loans to estimate the magnitude of realized excess returns on commercial mortgages. Our findings are striking. We find that average realized excess returns on commercial mortgages are the lowest at the best times á la Stiglitz and Weiss (Am. Econ. Rev., 71:393–409, 1981). We also find that excess realized returns on commercial mortgages are low when lenders are swamped with funds (which we measure by the volume of commercial mortgage commitments) and when promised spreads are low.      

Borrower Self-Selection,Underwriting Costs,and Subprime Mortgage Credit Supply

In the U.S., households participate in two very different types of credit markets. Personal lending is characterized by continuous risk-based pricing in which lenders offer households a continuous distribution of borrowing possibilities based on estimates of their creditworthiness. This contrasts sharply with mortgage markets where lenders specialize in specific risk categories of borrowers and mortgage supply is stepwise linear. The contrast between continuous lending for personal loans and discrete lending by specialized lenders for mortgage credit has led to concerns regarding the efficiency and equity of mortgage lending. This paper sheds both theoretical and empirical light on the differences in the two credit markets. The theory section demonstrates why, in a perfectly competitive credit market where all lenders have the same underwriting technology, mortgage credit supply curves are stepwise linear and lenders specialize in prime or subprime lending. The empirical section then provides evidence that borrowers are being effectively sorted based on risk characteristics by the market.     

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.     

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.     

Pricing Effects of the Decision to Sell or Hold Adjustable Rate Mortgage Loans in a Portfolio

Residential mortgage originators can transfer loans to ultimate lenders quickly and efficiently using the secondary mortgage market. Some adjustable rate mortgage (ARM) lenders use this outlet consistently while others hold whole loans in their portfolios on a long-term basis. Selling and holding lenders should respond to different economic factors when setting yields on ARM loans originated because their long-term positions in the loans are so diverse. This paper develops and tests a model of differential pricing behavior for selling and holding strategies. Empirical results support the notion that lenders use different factors to price loans and that these factors are related to the risks faced by the originating lender given its origination strategy. Additional findings suggest that institutional and firm-specific pricing tendencies exist in the primary mortgage market for adjustable rate debt.     

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.     

Foreclosure Delay and Consumer Credit Performance

The deep housing market recession from 2008 through 2010 was characterized by a steep rise in number of foreclosures. The average length of time from onset of delinquency through the end of the foreclosure process also expanded dramatically. Although most individuals undergoing foreclosure were experiencing serious financial stress, the extended foreclosure timelines enabled them to live in their homes without making mortgage payments until the end of the foreclosure process, thus providing temporary income and liquidity benefits from lower housing costs. This paper investigates the impact of extended foreclosure timelines on borrower performance with credit card debt. Our results indicate that a longer period of nonpayment of mortgage expenses results in higher cure rates on delinquent credit cards and reduced credit card balances. Thus, foreclosure process delays may have mitigated the impact of the economic downturn on credit card default—suggesting that improvement in credit card performance during the post-crisis period would likely be slowed by the removal of the temporary liquidity benefits as foreclosures reach completion.