Temporal relationships among adjustable-rate mortgage indexes

This article investigates the linkage among six ARM indexes during the 1978–1989 period. Granger's direct causality test is used to examine their relationship within a rolling regression framework. The nonstationary properties of each index and selected pairs of indexes are investigated by using the unit root and cointegration tests. The empirical results confirmed their relationship has changed over this period and short-term rates lead the eleventh district cost-of-funds index. The implications of the empirical results from the perspectives of borrowers (ARM choice), lenders (pricing), and investors (security valuation) are also discussed.     

Posted rates and mortgage lending activity

In many metropolitan areas (MSAs) newspapers post mortgage terms for lenders in a manner designed to permit an easy comparison of discount points and note rates. Using these advertised rates for 73 lenders in three MSAs we examine 1) how applicants respond to short-run changes in relative rates, and 2) the relationship between the services provided and quality of applications received by lenders and their long-term market positions. We find that applicant flows increase when lenders lower their rates. We also find that persistent cross-lender differences in rates are associated with differences in product quality reflected in processing times, loan sales, and FHA/VA lending; and that high-risk borrowers tend to apply to lenders posting above-average rates.     

Teaser rates in conventional adjustable-rate mortgage (ARM) markets

This article examines the pricing of teaser rates on adjustable-rate mortgages (ARMs). The theory indicates that lenders may offset teaser rates on ARMs through an increase in upfront fees or points, through looser life of loan rate caps, or through higher contract rates after the teaser has expired. Cross-sectional regression results fail to reject the null hypothesis that teaser ARMs are correctly priced.     

On the valuation of reverse mortgage insurance

This article presents a closed-form formula for calculating the loan-to-value (LTV) ratio in an adjusted-rate reverse mortgage (RM) with a lump sum payment. Previous literatures consider the pricing of RM in a constant interest rate assumption and price it on fixed-rate loans. This paper successfully considers the dynamic of interest rate and the adjustable-rate RM simultaneously. This paper also considers the housing price shock into the valuation model. Assuming that house prices follow a jump diffusion process with a stochastic interest rate and that the loan interest rate is adjusted instantaneously according to the short rate, we demonstrate that the LTV ratio is independent of the term structure of interest rates. This argument holds even when housing prices follow a general process: an exponential Lévy process. In addition, the HECM (Home Equity Conversion Mortgage) program may be not sustainable, especially for a higher level of housing price volatility. Finally, when the loan interest rate is adjusted periodically according to the LIBOR rate, our finding reveals that the LTV ratio is insensitive to the parameters characterizing the CIR model.     

Forecasting state- and MSA-level housing returns of the US: The role of mortgage default risks

We analyze the ability of an index of mortgage default risks (MDRI) for 43 states and 20 metropolitan statistical areas (MSA) of the US derived from Google search queries, in predicting (in- and out-of-sample) housing returns of the corresponding states and MSAs, based on various panel data and time-series approaches. In general, our results tend to prefer the panel data model based on common correlated effects estimation. We highlight that growth in MDRI negatively impacts housing returns within-sample, with predictive gains primarily concentrated beyond a year. These results are robust to alternative out-of-sample periods and econometric frameworks. Given the role of house prices as a leading indicators, our results are of value to policymakers, especially at the longer-run.     

The valuation at origination of fixed-rate mortgages with default and prepayment

This paper develops a model to rationally price fixed-rate mortgages, using the arbitrage principles of option pricing theory. The paper incorporates amortization, prepayment and default in valuing the mortgage. Having completely specified the model, numerical procedures value the different features of the mortgage contract under a variety of economic conditions. The necessity of having both the interest rate and the house price as explanatory variables, due to the interaction of default and prepayment, is demonstrated. The numerical solutions presented center around mortgage pricing at origination. Thus, variations in the equilibrium contract rate are examined for differing economic conditions and changes in the contract. Finally, by presenting a complete model, the paper yields insights for the existence of common institutional practices.     

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.     

Subprime mortgage funding and liquidity risk

In this article, we use actuarial methods to solve a nonlinear stochastic optimal liquidity risk management problem for subprime originators with deposit inflow rates and marketable securities allocation as controls. The main objective is to minimize liquidity risk in the form of funding and credit crunch risk in an incomplete market. In order to accomplish this, we construct a stochastic model that incorporates originator mortgage and deposit reference processes. Finally, numerical examples that illustrate the main modeling and optimization features of the article are provided.     

Valuing and hedging fixed rate mortgage commitments

A fixed rate loan commitment that is binding on the lender but not on the loan applicant is equivalent to a put option. This article uses the Black-Scholes option pricing model to establish a value for fixed rate loan commitments and to derive the hedge ratio for the lending institution to hedge the interest rate risk associated with the commitments in the FHLMC forward market for mortgages. The effectiveness of the resulting hedge is tested in a simulation, where it is found that the result is a 71% reduction in the variance of the value of the lender's gain or loss associated with the commitment period.     

The ins and outs of mortgage debt during the housing boom and bust

From 1999 to 2013, U.S. mortgage debt doubled before contracting sharply. I estimate mortgage inflows and outflows that shed light on the sources of volatility. During the boom, inflows from real estate investors tripled, far outpacing other segments such as first-time homebuyers. During the bust, a collapse in inflows keyed the debt decline, while an expansion of outflows due to defaults played a more minor role. Inflow declines partly reflect a dramatic falloff in first-time homebuying, especially for low credit score individuals. Further analysis helps support the notion that the differential decline by credit score reflects markedly tightened credit supply.     

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 model of mortgage losses and its applications for macroprudential instruments

We develop a theoretical model of mortgage loss rates that evaluates their main underlying risk factors. Following the model, loss rates are positively influenced by the house price level, the loan-to-value of mortgages, interest rates, and the unemployment rate. They are negatively influenced by the growth of house prices and the income level. The calibration of the model for the US and Switzerland demonstrates that it is able to describe the overall development of actual mortgage loss rates. In addition, we show potential applications of the model for different macroprudential instruments: stress tests, countercyclical buffer, and setting risk weights for mortgages with different loan-to-value and loan-to-income ratios.     

Political influence and banks: Evidence from mortgage lending

We show that banks expand mortgage lending in the home states of Senate Banking Committee chairs, and the effect is more pronounced in counties where the incumbent senator faces a competitive re-election race. Banks strategically target politically active borrowers. Consequently, banks’ profitability increases after favoring the incumbent politicians’ constituents, but they suffer a deterioration in mortgage asset quality in the long run. Our findings imply that political power could distort private capital allocation beyond conventional political contribution channels.     

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.     

Real estate market transparency and default on mortgages

This paper investigates the relationship between real estate market transparency (RET) and default on mortgages (DOM). Using data from 46 countries for the period of 2006–2016, we find evidence that there is a negative and significant relationship between RET and DOM. This result is robust with the inclusion of control variables and different estimation methods including panel fixed effects and generalized method of moments (GMM). We also find that the association between RET and DOM is more apparent in emerging economies than high-income countries.     

The good,the bad and the impaired: A credit risk model of the Irish mortgage market

Using a uniquely constructed loan-level dataset of the residential mortgage book of Irish financial institutions, this paper provides a framework for estimating default probabilities of individual mortgages. In contrast to the popular stock delinquency approach, this model provides estimates of default and cure flows: a requirement of the stress test approach adopted by the European Central Bank's comprehensive assessment. In addition, both default and cure transitions are modelled as functions of micro- and macro-covariates including loan characteristics and current macroeconomic conditions such as house prices and unemployment. When comparing the competing equity and affordability effects, labour market deterioration played a stronger role than house equity in the rise of Irish default rates. For cures, a scarring effect of default is identified and estimated with the probability of a loan returning to performing reducing by almost four per cent each month a loan remains delinquent.     

The price,quality and distribution of mortgage payment protection insurance: A hedonic pricing approach

Mortgage payment protection insurance (hereafter MPPI) provides varying combinations of accident, sickness and unemployment insurance and is used to protect the mortgage payments of policyholders in the event of a fall in income. Despite alleviating housing market failures, this service has been heavily criticised for providing poor value for money and being associated with unhelpful sales techniques especially when sold jointly with a mortgage in the UK. Consequently, the Competition Commission (2009) ruled that after February 2011 MPPI should not be sold jointly with mortgage lending within seven days of the credit transaction. We examine whether this prohibition was justified and if the form of distribution, either jointly with the mortgage or independently influences the premium levels. This assessment uses a hedonic pricing approach with details and premiums of MPPI policies in 2010 and 2012. Despite the success in reducing MPPI premium levels, we conclude that the Competition Commission judgement has raised concerns as to mortgagee protection.     

Loss coverage and stress testing mortgage portfolios: A non-parametric approach

This paper outlines the development of a practical approach to simulating a credit loss distribution function and to implementing a stress test exercise focusing on the entire Spanish mortgage portfolio. Specifically, we determine, via regression model, the main factors that explain why households fail to meet their mortgage payment commitments. This allows us to assign individual borrowers’ PDs and to estimate a rating system for the mortgage portfolio. Then, we simulate the empirical distribution function of mortgage loss rates using a Monte-Carlo resampling method, and compare the loss rates from this function with those provided by the Basel II IRB formulas. Finally, we assess, by running a stress exercise, the ability of banks to withstand certain adverse situations. The main result from this exercise is that, in general terms, Basel II IRB regulatory loss coverage offers fairly adequate protection for banks.