On the Economics of Subprime Lending

US mortgage markets have evolved radically in recent years. An important part of the change has been the rise of the subprime market, characterized by loans with high default rates, dominance by specialized subprime lenders rather than full-service lenders, and little coverage by the secondary mortgage market. In this paper, we examine these and other stylized facts with standard tools used by financial economists to describe market structure in other contexts. We use three models to examine market structure: an option-based approach to mortgage pricing in which we argue that subprime options are different from prime options, causing different contracts and prices; and two models based on asymmetric information–one with asymmetry between borrowers and lenders, and one with the asymmetry between lenders and the secondary market. In both of the asymmetric-information models, investors set up incentives for borrowers or loan sellers to reveal information, primarily through costs of rejection.     

The impact of settlement period on sales price

This study is an empirical investigation of the impact of settlement period on sales price while controlling for marketing period and standard explanatory variables. The hypothesized positive relationship between settlement period and sales price is confirmed by the results of this study. The estimated coefficient on settlement period is 0.0008 meaning that our market, on average, exacts a premium of 0.08 percent per day of settlement period beyond a norm of 60 days. The estimated coefficient on marketing period (a control variable) is –0.0003 meaning that our market, on average, requires a discount of 0.03 percent per day of marketing period. Our findings show the relative importance of settlement period in making real estate pricing decisions.     

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.     

The “Rent-To-Own” mortgage and prepayment risk

The most important risk factor in the mortgage and mortgage-backed security market has been prepayment risk. Various innovations have arisen to deal with it but none hedge it fully. The Rent-To-Own (RTO) mortgage discussed here is a mortgage instrument that reduces or even reverses prepayment risk. It does so by creating an incentive structure within the framework of the mortgage contract that penalizes prepayment when interest rates are low and rewards it when interest rates are high. This is the opposite of standard mortgages. The RTO incentive structure is based on a unique buyout feature. Borrowers who want to buy out the financial interest of the lender may do so whenever they want, but the buyout price is a negative function of the market interest rates prevailing currently, that is, at the time of the buyout. Hence the lower these rates, the higher the buyout price. Other advantages of the RTO mortgage are also described.     

Interest-only and principal-only mortgage strips as interest-rate contingent claims

Interest-only (IO) and principal-only (PO) mortgage strips are valued in a stochastic interest-rate environment. The prepayment rate of the underlying mortgages is affected by two considerations not present in the pure financially rational model: (1) The property owner's holding period is assumed to follow a Gamma distribution, resulting in the possibility of prepayment due to the sale of the property (i.e., prepayment that is too early based on market interest rates); and (2) borrowers are assumed to face heterogeneous transaction costs related to refinancing the existing mortgage, and delay refinancing when market conditions make it optimal to do so (refinancing too late). Properties of IO/PO strips are identified by the finite difference method.     

Integration in the mortgage market

The deregulatory trend and advances in technology during the 1980s removed many restrictions on the ability of U.S. depository financial institutions to obtain and redistribute funds across diverse geographical markets. This pervasive deregulation and innovation should have increased the degree of integration between different geographical financial markets. Yet there is little empirical evidence available on the validity of this expectation. It is important to provide such evidence since much of the U.S. depository institution regulatory policy is predicated on the assumption of highly localized, segmented financial markets. Considering alternative breakpoints at 1980 (DIDMCA) and at 1982 (Garn-St Germain), the current study tests the hypothesis that the degree of geographical financial integration after this period exceeded that prior to this period. Mortgage markets are focused on due to their historical importance in the regulation of funds flows. The study finds a significant increase in the mean contemporaneous correlation among FHLB districts' mortagage rate residuals in a vector-autoregressive system between two test periods. Further analysis shows that the distance between FHLB districts' headquarters and their respective pairwise interdistrict correlation coefficients are negatively related in the prior period but not significantly related in the later period. Economic booms and busts alternated among the districts over the two sample periods in a manner consistent with the reallocation of capital among more integrated financial markets. Individual districts' mortgage rates have been more sensitive to variations in national credit market conditions since deregulation was legally recognized by DIDMCA in 1980. Thus, the collective empirical evidence found in this study indicates that mortgage markets have responded to deregulation and marked technological advances by moving toward a national, highly integrated market. Regulators' preoccupation with highly localized, segmented markets must consequently be reexamined.     

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.     

Does credit rationing affect residential investment? Déjà vu all over again

This paper develops an empirical model to examine the impacts of credit rationing on residential investment for the 1960–1984 period. Our statistical results strongly support the position that noninterest rate variables affect mortgage activity and housing construction. Though we find a structural change in the housing construction and mortgage markets in the early 1980s, probably attributable to capital market integration and financial institutional deregulation, noninterest rate terms continue to matter. In other words, credit rationing continues to be an allocative device in the housing and mortgage markets.Earlier versions of this article have been presented at the Western Economic Association Conference, Los Angeles, June 1988; the Tenth Pacific Regional Science Conference, Pusan, Korea, July 1987; the AREUEA Annual Meetings New York City, December 1985; and the American Finance Association Annual Meetings, San Francisco, December 1983.     

A note on January returns in the U.S. government bond market: The term effect

This study documents a previously unobserved January effect in the market for riskless debt. Long-term government bonds have significantly lower returns in January than in the rest of the year. This January effect is opposite in sign to the January effects that have been previously documented in the markets for equity and the markets for risky debt. Tax-loss selling in the equity markets in conjunction with parking the proceeds may provide a possible explanation for the negative January effect in the market for government bonds.     

Supervisor and Market Analysts: What Should Research be Seeking?

This article is primarily directed towards examining the desirability of incorporating market signals in the process of supervision of commercial banks by regulators and insurers. But the ideas developed here can also be applied to the general problem of using market information to assess the solvency and safety of any financial or non-financial institution.Market prices and yields of securities anticipate actions by regulators, central banks, and other players due to the fact that such actions may materially influence the risk and the expected return associated with investment decisions pertaining to those securities. It is well known that the yield curve of government securities such as T-bills, T-notes and T-bonds reflect the market's consensus regarding the actions that the Federal reserve may take as they pertain to the valuation of such securities. The extent to which the market has already discounted the future actions of the central bank will no doubt play a role in the way in which the central bank may think about its actions, its actual effect and how it relates to its intended effects.The extent to which market prices can provide useful guides depends on the underlying market structure and the practices in the industry.While markets may do lot of the hard work in aggregating and incorporating future actions, the task of supervision and regulation can never be put on automatic pilot. Ideally, supervisory policies should effectively combine the market signals with initiatives that serve to maintain the safety and the soundness of the underlying markets. I will begin by exploring the extent to which equity prices may be used as a signal of bank credit risk. I will then explore the advantages and disadvantages of using subordinated debt securities to derive a market signal.     

Heterogeneity in Financial Market Participation: Appraising its Implications for the C-CAPM

This paper presents empirical evidence that accounting for heterogeneity in financial market participation is important for evaluating the empirical performance of the Consumption-based Capital Asset Pricing Model (C-CAPM). Using the US Consumer Expenditure Survey as a common testing ground, I re-assess three well-known characterizations of the equity premium puzzle (i) the inconsistency of the representative agent's IMRS with Hansen and Jagannathan bounds; (ii) Mehra and Prescott's calibration of a large representative agent's risk aversion; (iii) Hansen and the Singleton's large structural estimates of the preference parameters based on aggregate data. In all three cases, the estimates of risk aversion conditional upon financial market participation are not as far from reasonable values as the corresponding unconditional ones. The differences suggest that part of the equity premium puzzle can be accounted for by the use of a representative agent assumption rather than a more appropriate "representative stockholding agent assumption.     

The relationship between the demand and supply of home financing and neighborhood characteristics: An empirical study of mortgage redlining

In this study the hypothesis that central cities are redlined was tested with data gathered from three separate central city and matching city-suburban areas. Potentially unmet mortgage demand was estimated from interviews of people who tried unsuccessfully to sell their homes. A hedonic price function revealed that these owners did not overprice their homes. However, they did not attribute their inability to sell to potential buyers' problems with financial institutions. A logit analysis of data provided by home buyers showed that individuals bought in the areas they preferred. We also found that central city and city-suburban home buyers got the type of mortgage they wanted at market terms and home owners in both areas had no difficulty in financing home repairs.This study was supported by the National Science Foundation, Grant No. SES8000 482.     

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.     

Failed delivery and daily Treasury bill returns

If the seller of a Treasury bill does not provide timely and correct delivery instructions to the clearing bank, the bank does not deliver the security. Furthermore, the seller is not paid until this failed delivery is rectified. Since the purchase price is not changed, these fails generate interest-free loans from the seller to the buyer. This article studies the effect of failed delivery on Treasury bill prices. We find that investors bid prices to a premium to reflect the possibility of obtaining the interest-free loans that fails represent. This premium is a function of the opportunity cost of the fail. We also find that the bid-ask spread varies directly with the length of the fail. We rule out that our results are due to liquidity premiums, or to a general weekly pattern in short-term interest rates or the bid-ask spread.     

German rail vehicle construction in the context of market globalisation

Conclusion In the guise of ABB Daimler-Benz Transportation and Siemens, Germany has two powerful systems suppliers in a good position to keep pace with other systems suppliers on global markets. As in the air-travel industry it is conceivable that developments are moving towards a uniform rail technology. Although the buy national principle still dominates procurement practices, and national egos still dominate the development of rail systems (ICE, TGV), growing competition from Japan could force Europe to develop a European system. This would significantly increase the chances of European industry in bidding for international contracts. For this reason the EU should not relent in its efforts to standardise European rail systems.     

Conduit Entities: Implications of Indirect Tax-Efficient Financing Structures for Real Investment

As well known, companies shift income from high to low tax jurisdictions. Typically, profit shifting is achieved by direct financing structures whereby companies use debt finance in the high tax entity and equity finance in the low tax entity. However, certain tax policies can lead to indirect financing structures whereby a conduit entity provides an opportunity to achieve at least two deductions for interest expenses for an investment made in the host country. The effect of direct and indirect financing structures on real investment is compared.     

Corporate Real Estate and Stock Market Performance

An interesting question in corporate real estate literature is whether real estate can improve the stock market performance of property-intensive non-real estate firms. Using a data set comprising 75 non-real estate corporations that own at least 20 percent properties, this paper empirically assesses and compares the pair-wise return, total risk, systematic risk and Jensen abnormal return performance of composite (with real estate) and hypothetical business (without real estate) firms. We employed Morgan Stanley Capital International world equity index instead of a local market index to provide some insights into the performance of the local market relative to the global market during the 1997–2001 volatile periods experienced by many Asian countries. Our results suggest the inclusion of real estate in a corporate portfolio appears to be associated with lower return, higher total risk, higher systematic risk and poorer abnormal return performance. It is therefore likely that non-real estate firms own properties for other reasons in addition to seeking improvement in their stock market performance. Further research is needed to explore the main factors contributing to corporate real estate ownership by non-real estate firms.     

Balance Sheets, the Transfer Problem, and Financial Crises

In a world of high capital mobility, the threat of speculative attack becomes a central issue of macroeconomicpolicy. While first-generation and second-generation models of speculative attacks both have considerablerelevance to particular financial crises of the 1990s, a third-generation model is needed to make sense of thenumber and nature of the emerging market crises of 1997-98. Most of the recent attempts to produce such amodel have argued that the core of the problem lies in the banking system. This paper sketches another candidatefor third-generation crisis modeling—one that emphasizes two facts that have been omitted from formal modelsto date: the role of companies' balance sheets in determining their ability to invest, and that of capital flows inaffecting the real exchange rate.     

A New Approach to Group Structure, Burden Sharing, and the Equilibrium Provision of Public Goods

In the received model of the voluntary provision of a pure public good, the usual practice is to proceed from assumptions about the group characteristics to inferences about an implied outcome. The approach advocated in this paper reverses the traditional direction. Assuming a Nash equilibrium, we ask how to characterize the diverse set of group characteristics which will support it. Approaching the problem from this angle we define three crucial characteristics of a group-equilibrium: consumer's free rider inducing supply, zero contribution-inducing wealth and voluntary surplus tribute which is the amount by which a person's actual income exceeds his/her zero-contribution inducing wealth. Defining these indicators we show how they form the foundation of a complete mapping between the distribution of individual characteristics of a group, and equilibrium public good supply. Certain questions such as the interaction between size of the group and heterogeneity of incomes and tastes not yet adequately addressed are shown to yield easily to this approach.     

What is the Truth About the Scale of Japanese Banks' Bad Debts? Is the Situation Manageable?

In January 1998, the Japanese Ministry of Finance (MoF, 1998) released figures which suggested that the Japanese banking industry';s bad debts might be as high as ¥77 trillion (since revised upward to ¥87.5 trillion, if cooperative-type institutions are included; Financial Supervisory Agency (FSA), 1998). This compared with the previous official estimate of ¥28 trillion. The revelation was designed to do three things: (1) to convince investors, at home and abroad, who had long suspected that the true level of bad debts was much higher than the authorities (and the banks) were willing to admit to, that the authorities were sincere in their quest to enhance disclosure by local financial intermediaries; (2) to stifle opposition to the government's plans to use up to ¥30 trillion (since increased to ¥60 trillion) of public funds to stabilize the financial system¹ by underlining the gravity of the situation facing the Japanese economy; and (3) to pave the way for the introduction of more transparent reporting by the banks in April 1998 when a regime of prompt corrective action (PCA)² was scheduled to commence. This article explains the evolution of bad debt disclosure by the Japanese banking industry and assesses the significance of the latest figures. In particular, it highlights the extent to which accounting forbearance has been, and continues to be, used to mask the true level of the banks' bad debts and refutes the claim that the industry's bad debt burden peaked in 1995. The banking industry's ability to handle the continuing bad debt problem, in the face of a significant impairment of economic capital and the market's relentless drive for full disclosure and transparency, also is assessed.