The Effects of Purchases of Mortgages and Securitization by Government Sponsored Enterprises on Mortgage Yield Spreads and Volatility

In this paper, we investigate the effects of GSE (government sponsored enterprise) activities on mortgage yield spreads and volatility. Using various regression procedures (i.e., vector error correction (VEC) and GARCH models) and controlling for default and prepayment risk, we find that securitizations and purchases of mortgages by GSEs reduce mortgage yield spreads and volatility. In particular, we find that the yield spread between conforming and 10-year constant maturity treasury (CMT) rates decreases by 8.0 bp per $1billion increase in the level of GSE securitizations. Similarly, if GSEs increase mortgage purchases, the yield spread decreases 10.5 bp per $1billion increase of purchases. In addition, we hypothesize and find that GSE activities have a spillover effect to the non-conforming mortgage market; via investor substitutions, GSE purchases and securitizations of conforming loans reduce non-conforming loan rates. Thus, the measured influence of GSE activities is biased downward when measured using the spread of non-conforming loans over conforming loan rates. We also find that purchases of mortgages by GSEs significantly reduce mortgage yield volatility. In sum, our findings show that GSE activities reduce and stabilize mortgage market rates.     

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.      

From new deal institutions to capital markets: Commercial consumer risk scores and the making of subprime mortgage finance

The investment fueled US mortgage market has traditionally been sustained by New Deal institutions called government sponsored enterprises (GSEs). Known as Freddie Mac and Fannie Mae, the GSEs once dominated mortgage backed securities underwriting. The recent subprime mortgage crisis has drawn attention to the fact that during the real estate boom, these agencies were temporarily overtaken by risk tolerant channels of lending, securitization, and investment, driven by investment banks and private capital players. This research traces the movement of a specific brand of commercial consumer credit analytics into mortgage underwriting. It demonstrates that what might look like the spontaneous rise (and fall) of a ‘free’ market divested of direct government intervention has been thoroughly embedded in the concerted movement of calculative risk management technologies. The transformations began with a sequence of GSE decisions taken in the mid-1990’s to implement a consumer risk score called a FICO^® into automated underwriting systems. Having been endorsed by the GSEs, this scoring tool was gradually hardwired throughout the industry to become a distributed and collective ‘market device’. As the paper will show, once modified by specific GSE interpretations the calculative properties generated by these credit bureau scores reconfigured mortgage finance into two parts: the conventional, risk-adverse, GSE conforming ‘prime’ and an infrastructurally distinct, risk-avaricious, investment grade ‘subprime’.     

The Effect of Mortgage Price and Default Risk on Mortgage Spreads

Variations over time in mortgage yield spreads should reflect changes in the underlying prepayment option value; moreover, the relationship between mortgage yield spreads and interest rate dynamics should weaken as the value of the borrowers prepayment option declines. We verify this hypothesis through an empirical analysis of residential mortgage yield spread behavior, and we also present evidence that the strength of the relationship between mortgage spreads and interest rate dynamics weakens (strengthens) as the level of default risk increases (decreases). This result is consistent with the competing risks effect between a borrowers option to prepay or default. Our results demonstrate the importance of accounting for mortgage price discount to par as well as default risk when developing time series of mortgage yields.     

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.     

Credit Scoring and Mortgage Securitization: Implications for Mortgage Rates and Credit Availability

This article develops a model of the interactions between borrowers, originators, and a securitizer in primary and secondary mortgage markets. In the secondary market, the securitizer adds liquidity and plays a strategic game with mortgage originators. The securitizer sets the price at which it will purchase mortgages and the credit-score standard that qualifies a mortgage for purchase. We investigate two potential links between securitization and mortgage rates. First, we analyze whether a portion of the liquidity premium gets passed on to borrowers in the form of a lower mortgage rate. Somewhat surprisingly, we find very plausible conditions under which securitization fails to lower the mortgage rate. Second, and consistent with recent empirical results, we derive an inverse correlation between the volume of securitization and mortgage rates. However, the causation is reversed from the standard rendering. In our model, a decline in the mortgage rate causes increased securitization rather than the other way around.     

Fixed-Rate Endowment Mortgage and Mortgage Indemnity Valuation

We use a contingent claims framework for valuing the the default and prepayment embedded options in certain British fixed-rate endowment mortgages, with a (capped) mortgage indemnity guarantee (MIG). This methodology provides a template for the borrower, lender, and insurer to compare mortgage terms, including the fairness of contract rates, arrangement fees, prepayment penalties, any MIG premiums required, and co-insurance exposure. With empirical inputs, this model may eventually be useful as a mark-to-value proxy for all parties, as expected parameters change (especially interest rate and house price levels, and expected future volatilities), for purposes of determining valued added accounting, appropriate reserves, and indeed for setting premiums and business drivers. Fixed-rate endowment mortgages differ from fixed-rate repayment mortgages primarily because, in the event of early termination, the amount owed by the borrower is a function of the evolution of the term structure of interest rates, whereas for a repayment mortgage it is pre-determined. We compare endownment and repayment mortgages for different levels of loan-to-value ratios, interest rate and house price volatilities.     

Credit Counseling and Mortgage Termination by Low-Income Households

Published research on credit counseling and mortgage termination is surprisingly scarce, despite substantial growth in this industry. While the purpose of counseling is to assist low-income borrowers to improve their handling of debt and thereby reduce default, counseling may also improve the borrowers understanding of their financial position and thus induce optimal mortgage termination. Using a competing-risks framework, we study the effects on default and prepayment of a counseling program implemented in several Midwest states. We find weak evidence of that the default hazard was lower for graduates of the counseling program, but that their default behavior was more optimal. The prepayment hazard was higher for counseled borrowers, but their prepayment behavior was not more optimal. Overall, counseling seems to affect the lenders profits, but the net effect should be evaluated both in terms of prepayment and default.     

The Real Effects of FAS 166/167 on Banks’ Mortgage Approval and Sale Decisions

We examine the real effects of FAS 166 and FAS 167 on banks’ loan‐level mortgage approval and sale decisions. Effective in 2010, these standards tightened the accounting for securitizations and consolidation of securitization entities, respectively, causing banks to recognize an estimated $811 billion of securitized assets on balance sheet. We find that banks that recognize more securitized assets exhibit larger decreases in mortgage approval rates and larger increases in mortgage sale rates. These effects significantly exceed those of banks’ off–balance sheet securitized assets, consistent with our results being driven by the consolidation of securitization entities rather than by securitization per se. We conduct tests that help rule out the financial crisis as an alternative explanation for our results. Further analyses suggest that mechanisms underlying the results include consolidating banks’ reduced regulatory capital adequacy, increased market discipline, and consequent desire not to recognize high‐risk mortgages on balance sheet.     

Benefits to Homeowners from Mortgage Portfolios Retained by Fannie Mae and Freddie Mac

Mortgage investing is the domain of financial intermediaries, such as Fannie Mae and Freddie Mac, who possess specialized knowledge and experienced analytic teams. Capital is channeled to homeowner/borrowers at lower cost through such entities. As the demand for mortgage borrowing outstrips aggregate domestic saving (which is currently negative) foreign sources of capital should become even more significant. Foreign capital can be channeled efficiently into the U.S. mortgage market by Fannie and Freddie. Their debt has the highest credit standing and their risk management ability has been demonstrated by their enormous retained portfolios of mortgages.     

Mortgage Default: Classification Trees Analysis

We apply the powerful, flexible, and computationally efficient nonparametric Classification and Regression Trees (CART) algorithm to analyze real estate mortgage data. CART is particularly appropriate for our data set because of its strengths in dealing with large data sets, high dimensionality, mixed data types, missing data, different relationships between variables in different parts of the measurement space, and outliers. Moreover, CART is intuitive and easy to interpret and implement. We discuss the pros and cons of CART in relation to traditional methods such as linear logistic regression, nonparametric additive logistic regression, discriminant analysis, partial least squares classification, and neural networks, with particular emphasis on real estate. We use CART to produce the first academic study of Israeli mortgage default data. We find that borrowers features, rather than mortgage contract features, are the strongest predictors of default if accepting icbadli borrowers is more costly than rejecting good ones. If the costs are equal, mortgage features are used as well. The higher (lower) the ratio of misclassification costs of bad risks versus good ones, the lower (higher) are the resulting misclassification rates of bad risks and the higher (lower) are the misclassification rates of good ones. This is consistent with real-world rejection of good risks in an attempt to avoid bad ones.     

Measuring Potential GSE Funding Advantages

As the size of government sponsored enterprises (GSE) has grown, attention has focused on the relationship between the federal government and the GSEs, with particular attention focused on estimating the impact of this relationship on GSE debt costs. Quantifying the GSEs cost advantage is a controversial exercise with several competing methodologies providing divergent values. Thus, this paper reviews the methods that have been utilized in previous studies and recommends an alternative approach that overcomes many of the criticisms of previous work. By using offering yields on GSE debt, we find that the three housing GSEs enjoyed an average advantage of between 25 and 29 basis points over AA banking sector bonds, between 43 and 47 basis points over A rated bonds, and between 76 and 80 basis points over BBB rated banking issues. We find that our results are robust to both the basic approach taken as well as to model specification.     

Macroeconomic News and Mortgage Rates

The study analyzes the influence of macroeconomic news announcements on (a) interest rates for commercial mortgages, residential mortgages, 10-year Treasury notes, and Baa-rated corporate bonds; and (b) corresponding mortgage spreads. It is both interesting and highly relevant from a policy and portfolio management standpoint to examine the implications of the influence of macroeconomic news announcements on mortgage markets. Some important results are reported. First, consistent with the notion of market integration, mortgage rates are found to be co-integrated with other capital market instruments. Second, of the 22 types of periodic macroeconomic news releases considered, 13 of them have a significant influence on at least one of the interest rates, and notably changes in hourly earnings and housing starts significantly influence all debt-security yields. More generally, macroeconomic news that conveys higher inflation and/or economic growth has a positive influence on mortgage and other interest rates. Finally, this study finds several announcements including durable goods orders, new home sales, personal consumption, non-farm payroll, trade balance and Treasury budget to have a significant influence on mortgage spreads.     

Pricing fixed rate mortgages: Some empirical evidence

We develop a simple model based on the hypothesis that yields in the secondary mortgage market provide a basis for pricing new loans in the primary mortgage market. The model is then expanded to include potential interest rate variations due to lender characteristics and whether the loans meet securitization requirements. The empirical results, using a two-year sample of single-family mortgage rates, conform to the predictions of the model. In particular, we find that the interest rates on FRMs in the primary market move in a one-to-one relationship with secondary market yields. We also find significantly lower interest rates on these mortgages that can be sold in the secondary market versus those that cannot, thus indicating the value of the ability to securitize mortgages.     

Identifying the Effect of Securitization on Foreclosure and Modification Rates Using Early Payment Defaults

This paper develops and estimates an instrumental variables strategy for identifying the causal effect of securitization on the incidence of mortgage modification and foreclosure based on the early payment default analysis performed by Piskorsi et al. (J Financ Econ 97:360–397, 2010). Estimation results show that securitized mortgages are more likely to be modified and less likely to be foreclosed on by servicers. These results are consistent with the interpretation in Adelino et al. (2009) that low modification rates are not the result of contract frictions inherent in the mortgage securitization process.     

Environmental Conditions,Reservation Prices,and Time on the Market for Housing

A general analytical model to describe the impact of environmental disamenities on duration of sales is derived. A statistical technique to recover a sellers reservation price is proposed. An econometric procedure that consistently estimates market duration and a sellers reservation price is described. An application to the impact of highway noise on property values and market duration is presented. The estimation results show that, while highway noise has a significant negative impact on forming reservation prices and predicting sale prices, the noise effect on duration of sales is not statistically significant. Empirical evidence also shows a negative impact of market duration on reservation prices, which indicates an updating process for reservation prices over time.     

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.     

Loan Portfolio Swaps and Optimal Lending

Theories on loan portfolio swap hedging are based on a portfolio-choice approach. This paper presents an alternative: a firm-theoretic model for bank behavior with loan portfolio swaps. Our paper derives the optimal loan rate and rate-taking loan amount of the banks portfolio, and relates them to the market loan rate, counterparty loan rate, swap default risk, capital-to-deposits ratio, and deposit insurance. We find that in the bilateral default risk approach, the comparative static results are generated by four factors: the banks risk magnitude about the equity market value, loan composition in the swap contract, the substitution effect in the loan portfolio, and the income effect from the swap transaction. The results imply that changes in the payoff asymmetry in the event of swap default and the banks regulatory parameters have a direct effect on the banks loan portfolio for lending and swap transactions.We would like to thank two anonymous referees for helpful comments and advice.     

Financial Distress and Bank Restructuring of Small to Medium Size UK Companies

We use a unique data set to study how U.K. banks deal with financially distressed small and medium-sized companies under a contractualist bankruptcy system. Unlike in the U.S., these procedures limit the discretion of courts to strict enforcement of debt contracts, without any dilution of creditors claims. We show that lenders and borrowers select a debt structure that avoids some of the market failures often attributed to a contractualist system. Collateral and liquidation rights are highly concentrated in the hands of the main bank, giving it a dominant position in restructuring or liquidating a defaulting firm. There is little litigation, and no evidence of co-ordination failures or creditors runs. However, there is some evidence that the banks dominance makes it lazy in monitoring, relying heavily on the value of its collateral in timing the bankruptcy decision.     

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.