Differential Access to and Pricing of Home Mortgages: 2004 through 2009

This article documents trends and drivers of the residential mortgage market during the years 2004 through 2009, specifically focusing on the access to and pricing of mortgages originated by African‐American and Hispanic borrowers, and by borrowers living in low‐income and minority communities. Our analysis relies on a rich set of proprietary data that allow more expanded insights than can be obtained from the Home Mortgage Disclosure Act (HMDA) alone. We show that access to mortgage credit increased between 2004 and 2006 for the borrowers we focus on in our study and declined dramatically thereafter. Trends in access to credit were driven primarily by the changing credit mix of mortgage applicants and secondarily by the replacement of the Federal Housing Administration (FHA) for subprime as the dominant mode of nonprime originations and tighter underwriting standards. Throughout our entire period of study, these borrowers also consistently paid higher prices for their mortgages; however, the extent of this differential varied considerably over time and across groups. These pricing trends were driven primarily by changes in the FHA and subprime shares as well as by the market's increasingly aggressive pricing of credit risk.     

Credit History and the FHA–Conventional Choice

Models explaining whether households choose conventional or FHA mortgage financing typically use differential insurance premiums, loan-to-value (LTV) and payment-to-income underwriting standards, and local economic conditions to explain household behavior. Using a large and geographically diverse sample, we expand the standard choice model by including measures of borrower credit history. We find that the ability of a homebuyer to avoid credit problems is an important part of the FHA–conventional choice. In addition, credit scores of FHA borrowers are worse on average than those of conventional borrowers, but as LTV increases credit scores of conventional borrowers deteriorate.     

Residential Mortgage Markets and the Cost of Mortgage Funds

Early federal housing finance policy appears to have been largely directed at making mortgages more marketable. The creation of FHA, FNMA and FHLMC were designed to homogenize the mortgage instrument and to develop a secondary market for it. Apparently because of a lack of demand for marketability by investors, extensive trading of mortgages has not developed. Nonetheless, the fantastic growth in mortgage pools (as well as the unanticipated growth in FNMA holdings) has increased competition in the supplying of some intermediation functions (mortgage bankers have greatly expanded originations and servicing), has improved interregional flows of mortgage funds, and has given mortgage borrowers a greater access to capital markets generally. The principal result has been a decline in the mortgage rate relative to other market rates, although the inflation-triggered explosion in the demand for mortgage funds in recent years appears to be offsetting the impact of the growth in federal credit broadly defined.     

The Borrower's Perceived Risk in Mortgage Choice

We investigate how borrowers perceive the risk in the adjustable rate mortgage (ARM) versus fixed rate mortgage (FRM) choice. We develop a mortgage choice model where the coefficient on the long‐term bond risk premium is conditional on the borrower's perceived risk. We show that the perceived risk fluctuates over time according to the short‐term interest rate level and housing market conditions. We find that when the short‐term rate level is high (low), the borrowers perceive low (high) risk of a short‐term rate rise, thus opting for ARMs (FRMs). Also, during a down housing market they become more risk‐averse perceiving higher risk in choosing ARMs. The perceived risk level alters the borrowers’ sensitivity to the long‐term bond risk premium.     

Foreclosure's Wake: The Credit Experiences of Individuals Following Foreclosure

While a substantial literature has examined the causes of mortgage foreclosure, there has been relatively little work on the consequences of foreclosure for the borrowers themselves. Using a large sample of anonymous credit bureau records, observed quarterly from 1999 through 2010, we examine the credit experiences of 330,000 borrowers before and after a foreclosure start. Our analysis documents the substantial declines in credit scores that accompany a foreclosure start and examines the length of time it takes individuals to return their credit scores to predelinquency levels. The results suggest that, particularly for prime borrowers, credit score recovery comes slowly, if at all. The lack of recovery appears to be driven by persistently higher delinquency rates on consumer credit (such as auto and credit card loans) in the years that follow their foreclosure start. Our results also indicate that the experiences of individuals whose mortgages entered foreclosure from 2007 to 2009 have followed a similar path to borrowers foreclosed earlier in the decade, though their postforeclosure‐start delinquency rates have been higher and, consequently, credit score recovery appears to be taking longer.     

Government Policies,Residential Mortgage Defaults and the Boom and Bust Cycle of Housing Prices

We develop a micro‐based macromodel for residential home prices in an economy where defaults on residential mortgages negatively affect housing prices. Our model enables us to study the impact of subprime defaults on prime borrowers and the impact of various government policies on the housing market boom and bust cycle. In this regard, our key conclusions are that (i) there is a contagion effect from subprime defaults to prime defaults due to the negative impact of subprime defaults and (ii) monetary policy is the most effective tool for decreasing mortgage defaults and increasing aggregate home prices in contrast to alternative government fiscal policies designed to loosen mortgage credit.     

Credit Restrictions and the Market for Commercial Real Estate Loans

This paper develops a model of the market for commercial real estate loans based on the variables used by investors and lenders in property decision-making: the income capitalization (cap) rate, the debt-coverage ratio and the loan-to-value ratio. Empirical results for aggregate United States real estate originations and commitments for 1970–93 indicate that loan demand is sensitive to the cap rate and to building permit issuance. The dominant criterion used by lenders is the debt-coverage ratio as opposed to the loan-to-value ratio, a finding which may have implications for underwriting standards and credit policy.     

Borrower Credit and the Valuation of Mortgage-Backed Securities

We study the valuation of mortgage-backed securities when borrowers may have to refinance at premium rates because of their credit. The optimal refinancing strategy often results in prepayment being delayed significantly relative to traditional models. Furthermore, mortgage values can exceed par by much more than the cost of refinancing. Applying the model to an extensive sample of mortgage-backed security prices, we find that the implied credit spreads that match these prices closely parallel borrowers' actual spreads at the origination of the mortgage. These results suggest that models that incorporate borrower credit into the analysis may provide a promising alternative to the reduced-form prepayment models widely used in practice.     

Are Adjustable‐Rate Mortgage Borrowers Borrowing Constrained?

Past research argues that changes in adjustable‐rate mortgage (ARM) payments may lead households to cut back on consumption. These outcomes are more likely if ARM borrowers are borrowing constrained, and we show in this article that ARM borrowers exhibit attitudes toward borrowing and behavior that are consistent with being borrowing constrained. Although the demographic and financial characteristics of ARM and fixed‐rate mortgage (FRM) borrowers are somewhat similar, ARM borrowers differ from FRM borrowers in their uses of credit and attitudes toward it. In addition, we find the consumption growth of households with an ARM is more sensitive to past income than the consumption growth of other households, suggesting the ARM borrowers may be subject to borrowing constraints that hinder their ability to smooth consumption.     

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.     

Self-Selection and Discrimination in Credit Markets

In this article we make two contributions toward a better understanding of the causes and consequences of discrimination in credit markets. First, we develop an explicit theoretical model of loan underwriting in which lenders use a simple Bayesian updating process to evaluate applicant creditworthiness. Using a signal correlated with an applicant's true creditworthiness and their prior beliefs about the distribution of credit risk in the applicant pool, lenders are able to evaluate an applicant's expected or "inferred" creditworthiness to determine which loans to approve and which to deny. Second, we explicitly model the self-selection behavior of individuals. Because these decisions shape lenders' prior beliefs about the distribution of credit risk, they also affect the Bayesian posterior from which lenders compute an applicant's inferred creditworthiness, implying that statistical discrimination can arise endogenously. As an example, we show that in a market in which only some lenders have Beckerian tastes for discrimination there are conditions under which lenders without racial animus will also discriminate. Our model's flexibility makes it ideal for analyzing a wide variety of empirical and policy questions.     

Reversing the Trend: The Recent Expansion of the Reverse Mortgage Market

Reverse mortgages allow elderly homeowners to tap into their housing wealth without having to sell or move out of their homes. However, very few eligible homeowners used reverse mortgages to achieve consumption smoothing until recently, when the reverse mortgage market in the United States witnessed substantial growth. In this article, I examine 1989–2007 loan‐level reverse mortgage data and conduct three sets of analyses to better understand the demand for reverse mortgages among elderly homeowners. First, I study the ZIP code characteristics correlated with reverse mortgage originations. Second, I show that recent reverse mortgage borrowers are significantly different from earlier borrowers in many respects. Third, I investigate the reasons why the reverse mortgage market experienced substantial growth in the mid‐2000s. Combining the reverse mortgage data with county‐level house price data, I find that higher house prices lead to more reverse mortgage originations. Specifically, the increases in house prices account for about one‐third of the overall growth in the reverse mortgage market from 2003 to 2007.     

Dynamic Credit Rationing in the Home Mortgage Market

In this study a model of dynamic credit rationing in the home mortgage market by a profit-maximizing financial institution is developed.
In the 1960s and 1970s it was widely believed that credit rationing was very important in the mortgage market. The recent deregulation and innovation in financial markets is belived to have resulted in a significant weakening of these availability effects. For the model developed it is shown that deposit diversification, such as the introduction of money market accounts in 1978, would tend to reduce the amount of any dynamic credit rationing that was occurring.     

Residential Mortgage Credit Derivatives

As the fallout from subprime losses clearly demonstrates, the credit risk in residential mortgages is large and economically significant. To manage this risk, this article proposes the creation of derivative instruments based on the credit losses of a reference mortgage pool. We argue that these derivatives would enable banks to retain whole loans while also enjoying the capital benefits of hedging the credit risk in their mortgage portfolios. In comparisons of hedging effectiveness, the analysis shows that instruments based on credit losses outperform contracts based on house price appreciation.     

Automated Underwriting and the Profitability of Mortgage Securitization

This paper develops a game-theoretic model of mortgage securitization, which is then used to examine a potential effect of automated underwriting. The paper's primary supposition is that automated underwriting lowers the costs to competitive mortgage originators and a monopolist securitizer of identifying mortgage applicants who are good credit risks. Faced with lower underwriting costs, originators will screen a larger number of mortgage applicants in the hopes of holding more good risks in their portfolios and passing through more bad risks to the securitizer. This mounting adverse-selection problem causes the securitizer's expected revenues to decline; this effect can outweigh the cost-saving benefit of automated underwriting, causing the securitizer's return on equity to fall.     

Information Externalities,Neighborhood Characteristics and Home Mortgage Pricing and Underwriting

Theories of rational redlining suggest thinness in housing markets should lead to greater uncertainty in house price appraisals, increasing mortgage denial rates or pricing. Empirical tests found support for this theory in mortgage underwriting using 1990s data. Using 2006 data and bank‐specific regression models, we revisit this topic in light of two developments leading to the recent mortgage bubble: the widespread securitization that allowed banks to shift loan risk to investors and the advent of risk‐based pricing. Consistent with expectations, we find that information externalities have become economically very small and have shifted from underwriting to pricing decisions.     

Interest Rate Risk, Residential Mortgages and Financial Futures Markets

Residential mortgage markets in both the United States and Canada have recently been dominated by instruments such as variable-rate and short-term rollover mortgages which require borrowers to assume a greater burden of interest rate risk. An outstanding question is whether this approach to risk allocation is Pareto optimal or whether there are other more effective methods of dealing with the risk created by interest rate volatility. This study examines the potential for shifting this risk from the mortgage market to the financial futures market. After considering the rationale for expecting that neither mortgage borrowers nor lenders wish to absorb the high levels of risk present in the existing financial environment, this study discusses the hedging of interest rate risk through financial futures markets. Empirical tests are then performed to evaluate the effectiveness of U.S. futures markets for hedging positions from the U.S. mortgage market. These results indicate that the interest rate risk inherent in residential mortgages can be substantially shifted through one or more positions in the existing futures contracts and long-term, fixed-rate mortgages may still be financially feasible under conditions of interest rate volatility.     

Optimal Sharing of Interest‐Rate Risk in Mortgage Contracts: The Effects of Potential Prepayment and Default

Much of the literature on the economics of mortgage markets has studied the fixed vs. adjustable‐rate mortgage choice made by individual borrowers. However, to decide if the outcome of such a choice is efficient or approximately so, it is necessary to explore the question of optimal risk‐sharing in mortgage contracts. But because only a small literature has studied this question, more research is clearly warranted. The present article helps fill this gap by developing a simplified version of Arvan and Brueckner's model, using it to characterize optimal contracts in the absence of mortgage termination, and then exploring how termination via prepayment or default affects optimal risk‐sharing. The broad conclusion of the analysis is that potential mortgage termination makes higher risk exposure for borrowers optimal.     

Bankruptcy Exemption,Home Equity and Mortgage Credit

This article examines the impact of state bankruptcy homestead exemptions on mortgage application outcomes. The empirical analysis controls for endogeneity problems by focusing on 55 urban areas that cross state borders using the Home Mortgage Disclosure Act files from 2001 to 2008. The results indicate that holding the loan‐to‐value ratio constant, a more generous homestead exemption encourages borrowers to buy more housing and take out larger mortgages. However, holding house value constant, a more generous homestead exemption discourages mortgage borrowing and results in more home equity. Moreover, benefits of the homestead exemption outweigh the costs of it to mortgage lenders.     

Refinancing Trends among Lower Income and Minority Homeowners during the Housing Boom and Bust

This article examines trends in mortgage refinancing activity during the housing boom and bust, with a focus on homeowners in lower income and minority market (LIMM) areas. Unlike any other period in recent history, during the boom LIMM homeowners refinanced their mortgages more frequently than non‐LIMM homeowners. This occurred primarily among borrowers for whom the refinance option was not in‐the‐money, and it is likely attributable to the concurrent growth of subprime, cash‐out refinancing. Following the 2007 mortgage market collapse, however, LIMM homeowners were less likely to refinance. This can be explained in part by systematic differences in home equity levels across borrowers.