An Analysis of the Ex Ante Probabilities of Mortgage Prepayment and Default

Observed mortgage prepayment and default rates have been far different than the ruthless option exercise rates predicted by contingent claims models of mortgage pricing. The discrepancies have been attributed to both the competing-risk nature of prepayment and default and to transactions costs. This paper tries a different means of reconciliation. We introduce a third stochastic process, household income, into the usual pricing model that includes only the spot interest rate and the house price. The presence of income allows considering consumption-theoretic determinants of termination. The role of mortgage underwriting rules in restricting optimal prepayment is also explicitly modeled. Numerical ex ante prepayment and default rates based on the theoretical model come much closer to historical experience.     

Adjustable and Fixed Rate Mortgage Termination, Option Values and Local Market Conditions: An Empirical Analysis

This paper analyzes the probabilities of prepayment or default for Fixed Rate Mortgages (FRMs) and Adjustable Rate Mortgages (ARMs). Using data from the period 1985–1992, the analysis indicates that the likelihood of prepayment of thirty year FRMs was determined primarily by house price appreciation and personal income growth and the likelihood of prepayment of fifteen year FRMs was determined primarily by interest rate changes. ARMs were prepaid less frequently than FRMs, were less likely to be prepaid when interest rates declined and defaulted more often than FRMs. The analysis provides evidence that ARM holders are less mobile than FRM holders.     

Prepayment Penalty as a Screening Mechanism for Default and Prepayment Risks

The objective of this article is to offer a theoretical model of asymmetric information to analyze the screening role of prepayment penalty. We consider both default risk and prepayment risk. What makes the role of prepayment penalty interesting and more complicated is that a borrower's contract choice could send conflicting signals to the lender about that borrower's default and prepayment risk type. This is different from earlier theoretical models of mortgage choice under asymmetric information where a certain aspect of the contract (e.g., discount points or loan‐to‐value ratio) is explored as a screening mechanism for a single risk dimension (default risk or prepayment risk) of the borrower type. We show the existence of separating equilibria where different default and prepayment risk types choose contracts with different combinations of prepayment penalty and interest rate. For certain parameter combinations, the model also generates a pooling equilibrium where all borrower types obtain the same contract. Our analysis could offer a partial explanation for the observation that contracts with prepayment penalties are a lot less prevalent than contracts with points.     

Amenity‐Based Housing Affordability Indexes

The recent slump notwithstanding, substantial increases in house prices in many parts of the United States have served to highlight housing affordability for moderate‐income households, especially in high‐cost, supply‐constrained coastal cities such as Boston. In this article, we develop a new measure of area affordability that characterizes the supply of housing that is affordable to different households in different locations of a metropolitan region. Key to our approach is the explicit recognition that the price/rent of a dwelling is affected by its location. Hence, we develop an affordability methodology that accounts for job accessibility, school quality and safety. This allows us to produce a menu of town‐level indexes of adjusted housing affordability. The adjustments are based on obtaining implicit prices of these amenities from a hedonic price equation. We thus use data from a wide variety of sources to rank 141 towns in the greater Boston metropolitan area based on their adjusted affordability. Taking households earning 80% of area median income as an example, we find that consideration of town‐level amenities leads to major changes relative to a typical assessment of affordability.     

Origination Channel,Prepayment Penalties and Default

This article presents evidence that nonbank‐originated subprime mortgages have a higher probability of default than bank‐originated subprime mortgages, but only for loans with prepayment penalties. Evidence also indicates that nonbanks price prepayment penalties less favorably to borrowers than banks do, and nonbanks originate disproportionately more loans with prepayment penalties in locales with less financially sophisticated borrowers. State antipredatory lending law provisions restricting the use of prepayment penalties eliminate the elevated default risk of nonbank originations relative to bank originations. These findings are consistent with incentives generated by nonbank compensation via yield spread premiums on loans with prepayment penalties.     

Pay Me Now or Pay Me Later: Alternative Mortgage Products and the Mortgage Crisis

Mortgage contract design has been identified as a contributory factor in the recent market crisis. Here we examine alternative mortgage products (including interest‐only and other deferred amortization structures) and develop a game theoretic model of contract choice given uncertain future income and house prices across different types of borrowers. Results imply that deferred amortization contracts are more likely to be selected in housing markets with greater expected price appreciation and by households with greater risk tolerance; moreover, such products necessarily entail greater default risk, especially among lower‐income households who are aggressive in housing consumption levels. Empirical tests of model predictions generally provide support for the theory.     

Financial Literacy,Broker–Borrower Interaction and Mortgage Default

This article examines the relationship between broker–borrower interaction in the origination process and subsequent mortgage performance. I show that face‐to‐face interaction between a mortgage broker and borrower before the loan funds is associated with lower levels of ex post default. The relation between face‐to‐face broker–borrower interaction and mortgage performance holds only for borrowers that have characteristics associated with low levels of financial literacy. Specifically, face‐to‐face interaction is negatively related to default for minorities, borrowers located in areas with low levels of education, low‐income borrowers and borrowers with low FICO scores. My results suggest that face‐to‐face interaction between the mortgage broker and borrower may reduce problems associated with financial illiteracy.     

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.     

Movers and Shuckers: Interdependent Prepayment Decisions

We model competing risks of mortgage termination where the borrower faces a repeated choice to continue to pay, refinance the loan, move or default. Most previous empirical work on mortgage prepayment has ignored the distinction between prepayments triggered by refinancing and moving, combining them into a single prepayment rate. We show that financial considerations are the primary drivers of the refinance choice while homeowner characteristics have more influence on the move decision. We demonstrate that these differences are statistically significant and that combining these two distinct choices into a single measure of prepayment shifts coefficients toward zero and produces inaccurate predictions of aggregate termination rates. For example, a combined model underestimates the effect of the market price of the loan on refinancing; it misses entirely the opposite effects of borrower income on moving and refinancing. Our results suggest that existing prepayment models are inconsistent predictors of mobility-driven prepayment and underestimate the effect of market conditions and borrower characteristics on refinancing and housing decisions. Our findings have great significance to mortgage investors because mobility-driven prepayments are likely to be a more significant source of prepayments in thenext decade.     

A Lattice Approach to Pricing Fixed-Rate Mortgages with Default and Prepayment Options

Existing models on the pricing of default and prepayment options in fixed-rate mortgages either use numerical methds or they do not consider refinancing or other transaction costs involved in default and prepayment. We provide in this paper an application of the Boyle [1] lattice model to price secured debt with two risky assets. This model is simple, efficient and capable of considering the major types of transaction costs involved in prepayment and default. Using our model, we estimate the option values under a range of assumptions about the underlying parameters. We also provide some comparisons of the lattice model estimates to other models in the literature.     

The Conditional Probability of Foreclosure: An Empirical Analysis of Conventional Mortgage Loan Defaults

This paper analyzes the factors affecting the conditional probability that defaulted residential mortgage loans will foreclose. We analyze a large national sample of conventional loans, which have been in default at least once during the 1988 to 1994 period. For such loans, lenders and borrowers either individually or jointly make choices which lead to the following outcomes: (1) resumption of payments, (2) termination by prepayment, or (3) foreclosure. Our estimates of a logit model indicate that termination option values and local area economic and housing market conditions affect default resolution probabilities. Perhaps more importantly, simulations using the logit model indicate that the efficiency of the default resolution process may be substantially improved by legal and regulatory reforms.     

The Impact of Housing Vouchers on Mobility and Neighborhood Attributes

This article examines the effect of receiving a housing voucher on the mobility and neighborhood attributes of low‐income households. Housing policy has shifted toward vouchers in lieu of public housing projects to allow households to move away from high‐poverty areas. We use administrative records collected from an experiment to examine this issue. We find that households moved immediately after receiving the subsidy but did not relocate to lower poverty neighborhoods until several quarters later. Our findings suggest that recipients initially lease in nearby units to secure the subsidy, while continuing to search for housing in lower poverty neighborhoods.     

The Termination of Commercial Mortgage Contracts through Prepayment and Default: A Proportional Hazard Approach with Competing Risks

This article examines the factors driving the borrower's decision to terminate commercial mortgage contracts with the lender through either prepayment or default. Using loan–level data, we estimate prepayment and default functions in a proportional hazard framework with competing risks, allowing us to account for unobserved heterogeneity. Under a strict definition of mortgage default, we do not find evidence to support the existence of unobserved heterogeneity. However, when the definition of mortgage default is relaxed, we do find some evidence of two distinctive borrower groups. Our results suggest that the values of implicit put and call options drive default and prepayment actions in a nonlinear and interactive fashion. Prepayment and default risks are found to be convex in the intrinsic value of call and put options, respectively. Consistent with the joint nature of the two underlying options, high value of the put/call option is found to significantly reduce the call/put risk since the borrower forfeits both options by exercising one. Variables that proxy for cash flow and credit conditions as well as ex post bargaining powers are also found to have significant influence upon the borrower's mortgage termination decision.     

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.     

Is Timing Everything? Race,Homeownership and Net Worth in the Tumultuous 2000s

We use the Panel Study of Income Dynamics to estimate how net worth was affected among low‐ and moderate‐income households who became first‐time homebuyers at different points during the volatile 2000s. We address selection using propensity score matching and estimating difference‐in‐difference models, and use quantile regressions to account for the skew in net worth outcomes. Results highlight the significance of race in the relationship between first‐time home buying and net worth during the decade. Although timing was critical to the short‐term trajectory of net worth for whites, total net worth declines for black first‐time homebuyers regardless of economic climate. The most dramatic differences between black and white new homebuyers is their neighborhood locations, with blacks purchasing in predominantly black neighborhoods with lower housing prices and price appreciation, and lower and declining rates of homeownership.     

Mortgage Prepayment and Default Decisions: A Poisson Regression Approach

This paper uses an extensive and geographically dispersed sample of single-family fixed rate mortgages to assess the prepayment and default behavior of individual homeowners. We make use of Poisson regression to efficiently estimate the parameters of a proportional hazards model for prepayment and default decisions. Poisson regression for grouped survival data has several advantages over partial likelihood methods. First, when dealing with time-dependent covar-iates, it is considerably more efficient in terms of computations. Second, it is possible to estimate full-hazard models which include, for example, functions of time as well as multiple time scales (i.e., age of the loan and calendar time), in a much more straightforward manner than partial likelihood methods for un-grouped data. Third, Poisson regression can be used to estimate non-proportional hazards models such as additive excess risk specifications. Taken together, our data and estimation methodology allow us to obtain a better understanding of the economic factors underlying prepayment and default decisions.     

Contemporaneous Loan Stress and Termination Risk in the CMBS Pool: How “Ruthless” is Default?

This study analyzes the impact of contemporaneous loan stress on the termination of loans in the commercial mortgage‐backed securities pool from 1992 to 2004 using a novel measure, based on changes in net operating incomes and property values at the metropolitan statistical area‐property‐type‐year level. Employing a semi‐parametric competing risks model for a variety of specifications, we find that the probability of default is extremely low even at very high levels of stress, although the coefficient estimates of greatest interest are very statistically significant. These results suggest substantial lender forbearance and are consistent with previous research that models default as a “gradual dynamic process” rather than a “ruthless” exercise once “in the money.”     

Reverse Mortgages and Prepayment Risk

This paper presents a detailed assessment of the Connecticut Housing Finance Authority (CHFA) reverse annuity mortgage (RAM) program. Because of the size and payment history of the program, the analysis provides an empirical framework on which to develop and assess other home equity conversion (HEC) programs. The program offers insights into the economic impact of these programs and the factors affecting prepayment. The program issued 765 annuities over five years, and 240 of these loans have terminated payments. The annuity payments had a demonstrable financial impact on the elderly participants, with an 88% average annual income increase. Prepayment rates varied across borrower and loan characteristics. The rates were most sensitive to marital status and were heavily affected by the age of the borrower and the term of the loan. Although default risk exists, the evidence indicates a low probability of the loan value exceeding the house value.     

Mortgage Loan Characteristics,Unobserved Heterogeneity and the Performance of United Kingdom Securitized Subprime Loans

We estimate a competing risk model of mortgage terminations on samples of U.K. securitized subprime mortgages. Given the role of these loans in the recent financial crisis it is important to understand their performance and supposed idiosyncratic behavior. We use a flexible modelling of unobserved heterogeneity over several dimensions, controlling for selection issues involving initial mortgage choices and dynamic selection over time. We estimate the characteristics of the unobserved heterogeneity and determine the correlation between the unobserved components of default and prepayment. The paper demonstrates the need to estimate initial household choices and the durations to default or prepayment jointly.     

Income, Location and Default: Some Implications for Community Lending

This paper investigates differences in default losses across income groups and neighborhoods, in an effort to see if there are significant differences between default experience on loans to low-income households or low-income neighborhoods and other loans. We find that while defaults and losses are somewhat higher in low-income neighborhoods, default behavior is similar in the sense that responses to negative equity are similar across neighborhoods, and remaining differences are small and might be explained by omitted variables such as those measuring credit history.