Determinants of Multifamily Mortgage Default

Option–based models of mortgage default posit that the central measure of default risk is the loan–to–value (LTV) ratio. We argue, however, that an unrecognized problem with extending the basic option model to existing multifamily and commercial mortgages is that key variables in the option model are endogenous to the loan origination and property sale process. This endogeneity implies, among other things, that no empirical relationship may be observed between default and LTV. Since lenders may require lower LTVs in order to mitigate risk, mortgages with low and moderate LTVs may be as likely to default as those with high LTVs. Mindful of this risk endogeneity and its empirical implications, we examine the default experience of 495 fixed–rate multifamily mortgage loans securitized by the Resolution Trust Corporation (RTC) and the Federal Deposit Insurance Corporation (FDIC) during the period 1991–1996. The extensive nature of the data supports multivariate analysis of default incidence in a number of respects not possible in previous studies. Consistent with our expectations, we find that LTV evidences no relationship to default incidence, while the strongest predictors of default are property characteristics, including three–digit ZIP code location and initial cash flow as reflected in the debt coverage ratio. The latter results are particularly interesting in that they dominated the influence of postorigination changes in the local economy.     

Choice of Mortgage Contracts: Evidence from the Survey of Consumer Finances

This study revisits the empirical question of the determinants of the choice between fixed‐ and adjustable‐rate mortgages using data from the Survey of Consumer Finances that overcome some of the data limitations in previous studies. The results from a logit model of mortgage choice indicate that pricing variables and affordability are important considerations. We also find that factors, such as mobility expectations, income volatility and attitudes toward financial risk largely influence mortgage choice, with more risk‐averse borrowers preferring fixed‐rate mortgages. For households that are less risk averse, the mortgage type choice decision is less sensitive to pricing variables and income volatility, and affordability factors are not significant. These findings provide empirical support that underscores the importance of attitudes toward risks in mortgage choice.     

Prepayment Behavior of Dutch Mortgagors: An Empirical Analysis

The suboptimal exercise of the prepayment option in a mortgage is relevant for mortgage pricing and the management of a mortgage portfolio. Construction of an accurate prepayment model requires quantification of driving factors such as seasoning, seasonality, refinance incentive and burnout. We focus on Dutch mortgages but also discuss the Dutch market in a European setting. Within the euro-denominated MBS market, the Dutch market is often referred to as the benchmark market. In our application we include typical Dutch market and contract characteristics such as the annual penalty-free prepayment of 10 to 20% of the original loan amount. We use loan-level historical data on mortgages originated between January 1989 and June 1999 to estimate separate models for two popular redemption types: savings mortgages and interest-only mortgages. In both models we allow for suboptimal prepayment behavior. The results clearly indicate that prepayment rates depend on interest rates and the age of the mortgage contract. Moreover, we find that burnout is an important element in describing the prepayment behavior of Dutch mortgagors.     

Explaining Refinancing Decisions Using Microdata

This paper develops a model which explains how mortgage-rate movements, transactions costs, changes in borrower income and house value, personal financial opportunities and the prepayment option embedded in fixed-rate mortgages affect a financially flexible borrower's decision to refinance an existing loan while retaining the underlying home. Broadening the focus of previous analytical work, the model explains why households with similar mortgage loans may react differently as financial market conditions change. It contains definitive empirical predictions that are supported by an analysis of a choice-based sample of individual loan transactions. Results suggest that refinancings are motivated both by movements in the level of interest rates and by borrowers' desires to alter their capital structures in the face of changing income and housing wealth.     

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.     

The Demand and Supply of Mortgage Funds and Mortgage Loan Terms

The supply of and demand for residential mortgages has been the subject of much discussion in the literature. Many of these studies have used single equation, partial adjustment models with the price specified as the contract rate. In this study, two of the assumptions that underlie these previous studies are tested empirically. First, the proper specification of the price of mortgage funds is tested by using both the contract rate alone and all of the terms of the mortgage as the price. Second, the speed of adjustment in the mortgage market is examined by estimating the model in both the instantaneous adjustment and partial adjustment forms. Both of these tests are carried out using a simultaneous equation rather than a single equation model. The empirical results indicate that the contract rate along with the loan initiation fees, the loan-to-value ratio and the maturity is the better specification of price and that the partial adjustment model performs better than the instantaneous model in the mortgage market.     

The Effects on Mortgage Repayments of Restrictions on the Enforcement of Due-on-Sale Clauses: The California Experience

Unexpected increases in the cost of mortgage funds have imposed substantial losses on mortgage lenders. The losses are compounded by the decline in mortgage repayments as homeowners hang on to their low-rate mortgages. The enforcement of due-on-sale clauses is one option lenders have had to inhibit reductions in the turnover of low-rate mortgages. Recently a California Supreme Court ruling restricted the use of due-on-sale clauses. As a result, California state-chartered associations can no longer use due-on-sale clauses to raise mortgage rates. At the same time, most federally chartered associations in California continued the unrestricted enforcement of due-on-sale clauses. This paper examines the behavior of repayment rates at restricted state and unrestricted federal associations in California. The results suggest that for each percentage point new mortgage interest rates exceeded rates on existing mortgages, repayment rates at federal associations declined by 1.532 percentage points. The inability to prevent mortgage assumptions caused repayment rates at state-chartered associations to fall 0.406 percentage points more than federal association repayment rates. The additional decline has added substantial income losses to California state associations.     

Pricing Default Risk in Mortgages

This paper examines the valuation of fixed-rate mortgages and the pricing of insurance against default on such mortgages. Both the mortgage and the insurance are treated as compound European put options. A put is the right, but not the obligation, to turn over an asset to another party for a specified payment, and being a European put indicates that this can only occur at a specified expiration date. The mortgage contract, and hence the insurance on it, fit into a European option framework because no rational borrower would ever choose to default until a payment is due. Mortgages are compound options in nature because at each payment data prior to the last one, the borrower either defaults or purchases a new option to default at the next payment date by making the scheduled payment. Since the current value of the mortgage is affected by options to default in the future, the problem is solved working backwards in time with the value of later options feeding into the earlier ones, so that the process builds on itself in a recursive fashion. Using familiar arguments from option-pricing theory, the value of any of the assets in the model is expressed as the solution to a partial differential equation, where the terms of the contract yield the appropriate terminal conditions. Standard numerical procedures are then used to produce the value of the mortgage and the insurance under various economic conditions. The simulations indicate that the prime determinants of the value of the assets considered are the volatility of the house price and the volatility of the spot interest rate. Sensitivity tests show that changing either of these parameters affects the results substantially more than any of the other parameters examined. The paper completely analyzes the default option and insurance against default on the mortgage. It is one part of a complete model of fixed-rate mortgages that would allow for both prepayment and default and treat the interaction of the two options. The general approach outlined in this paper can be used to develop such a model as well as to value any mortgage-related security. In light of the increasing variety and the complexity of such instruments in the market today, the presentation of our approach to these valuation problems is perhaps the most important contribution of the paper.     

The Subprime Virus

We examine the correlation between prime mortgage default risk and the introduction of subprime mortgages in a local area. We motivate our analysis with a model of a default contagion effect that spreads the effect of a mortgage foreclosure from one property to surrounding properties. Through numerical analysis, we demonstrate the effect of subprime mortgage originations to the risk of prime mortgages. Finally, we offer empirical support for our model by examining the spatial variation in MSA prime mortgage default rates and the level of subprime mortgage activity.     

Privatized Default Risk and Real Estate Recessions: The U.K. Mortgage Market

A mortgage pricing model is developed when a borrower goes through a series of distress states, including delinquency, long-term nonpayment and ultimate default. These steps are sequential, and depend on prices and alternatives faced by the borrower. The multistate default model is applied to the mortgage market in the United Kingdom. As a byproduct, a pricing structure for the U.K. endowment mortgage, which combines a good and a life insurance policy, is developed. Income and liquidity constraints are shown to affect the decision to keep a mortgage current in different states of distress. Solvent borrowers may thus keep their mortgages current, even when equity is negative.     

FHA Terminations: A Prelude to Rational Mortgage Pricing

Recent models of pricing mortgages and/or mortgage insurance have used option-pricing models as their framework. The focus is usually on default, which is viewed as a put option (to sell the house to the lender in exchange for the mortgage) and prepayment, which is viewed as a call option (to buy the mortgage from the lender). Analysis then uses techniques like those used to price options in capital markets. Unfortunately, homeowners do not seem to exercise their option as quickly as do traders in organized markets. We estimate prepayment and default functions, which are meant to be a first step in developing modified, option-based models of mortgage pricing.     

Reverse Mortgages and the Liquidity of Housing Wealth

Housing wealth constitutes most of the non-pension wealth of the elderly population. This study analyzes the potential of reverse mortgages to increase the income and liquid wealth of the elderly by identifying households with relatively high levels of housing equity. Because this article looks at the whole distribution of elderly households and considers debt as well as income, it finds a larger potential market for reverse mortgages than previous studies.
Calculations from the 1990 Survey of Income and Program Participation and Census population estimates show that over six million homeowners in the United States could increase their effective monthly income by at least 20% by using a reverse mortgage. Of these, more than 1.3 million have no children. Furthermore, a reverse mortgage would allow over 1.4 million poor elderly persons to raise their incomes above the poverty line.     

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.     

Modeling the Conditional Probability of Foreclosure in the Context of Single-Family Mortgage Default Resolutions

Both empirical and pricing-simulation models of mortgage default focus on foreclosure in a one-step decision framework. Such models are misspecified to the extent that mortgage default and foreclosure are two separate decisions or events, where foreclosure is but one outcome of a default episode. This study examines the dynamics of mortgage borrower default episodes using a large sample of FHA-insured single-family mortgages. We estimate the influence of borrower characteristics, mortgage terms, and economic conditions on probabilities of various resolutions, highlighting under what conditions foreclosure is more likely to result from mortgage default.     

Home Ownership,Household Leverage and Hyperbolic Discounting

I examine tenure and mortgage choice in an equilibrium model in which households make decisions as if they discount hyperbolically rather than exponentially. Overall, hyperbolic discounting does not seem to explain the high rates of home ownership or portfolio concentration in housing in the data. I then study the choice between mortgages that require a substantial down payment and mortgages that require no down payment. Allowing households access to no‐down‐payment mortgages exacerbates rather than mitigates the undersaving of hyperbolic discounters. However, even when households discount hyperbolically, welfare is higher when households have access to no‐down‐payment mortgages.     

Efficiency in the Mortgage Market: The Borrower's Perspective

This paper uses mortgage history data from the Federal Home Loan Mortgage Corporation to analyze the prepayment behavior of homeowners and to test whether borrowers exercise their prepayment options in a manner consistent with contingent claims models. A variety of hazard models are estimated from individual data on more than 6000 mortgages issued during the 1976–1980 period. In these models, it is clear that the extent to which the prepayment option is "in the money" has a strong effect on behavior. However, it is less clear that the option is exercised quite as ruthlessly as the theory predicts.     

Housing Price Dynamics,Mortgage Credit and Reverse Mortgage Demand: Theory and Empirical Evidence

This article presents some theoretical and empirical approaches for identifying interactions among fundamental economic variables that determine housing prices. Using home equity conversion mortgage (HECM) loan‐level data, this study quantifies the major risks of reverse mortgages and shows that higher housing prices induce higher demand for reverse mortgages among elderly homeowners. Senior citizens rationally hold pessimistic expectations about future housing price appreciation and lock in their home‐equity gains by obtaining reverse mortgages, which in turn led to the substantial HECM growth prior to the financial crisis of 2008. A novel simulation also forecasts HECM loans under various economic scenarios. From a mortgage credit perspective, these findings generate several policy implications for the implementation of “HECM 3.0.”     

Adjustable-Rate Mortgages, Economic Fluctuations, and Lender Portfolio Change

In this study we examine the effects of economic fluctuations on the repayment behavior of a portfolio of adjustable-rate mortgages (ARMs). Because the U.S. experience with ARMs is quite recent, we have used data on a form of ARM used in Canada, the rollover mortgage. The results of our analysis suggest that use of ARMs similar to the rollover mortgage may reduce but not eliminate interest-rate risk for lenders, as borrowers, albeit constrained, prepay above-market-rate loans. In addition, we find that the periodic payment change inherent in the rollover mortgage does not lead to higher default rates and, therefore, credit risk.     

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.     

Reverse Mortgages and Interest Rate Risk

We develop and apply a valuation model that quantifies the interest rate risk inherent in fixed-rate reverse mortgages. Consistent with intuition, our results show that the interest rate risk of a reverse mortgage is greater than that of either a typical coupon bond or a regular mortgage. Somewhat surprisingly, we find that this difference in interest rate risk is extremely large. In fact, the interest rate risk of a reverse mortgage often is several orders of magnitude greater than the interest rate risk of other fixed-income securities.