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.     

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.     

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.     

Thy Neighbor’s Mortgage: Does Living in a Subprime Neighborhood Affect One’s Probability of Default?

This article focuses on the potential externalities associated with subprime mortgage origination activity. Specifically, we examine whether negative spillover effects from subprime mortgage originations result in higher default rates in the surrounding area. Our empirical analysis controls for loan characteristics, house price changes and alternative loan products. Our results indicate that, after controlling for these characteristics, the concentration of subprime lending in a neighborhood does not lead to greater default risks for surrounding borrowers. However, we do find that more aggressive mortgage products (such as hybrid adjustable rate mortgages and low/no‐documentation loans) had significant negative spillovers on other borrowers. Stated differently, the aggressive alternative mortgage designs were more toxic to the housing and mortgage market than previously believed.     

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.     

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.     

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.     

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.     

The Government‐Sponsored Enterprises and the Mortgage Crisis: The Role of the Affordable Housing Goals

I use regression discontinuity analysis to measure the effect of one of the Affordable Housing Goals, the Underserved Areas Goal (UAG), on the number of whole single‐family mortgages purchased by Fannie Mae and Freddie Mac (GSEs) in undeserved census tracts for 1996–2002. Focusing additionally on tracts that became UAG‐eligible in 2005–2006, I measure the effect of the UAG during peak years for the subprime market. The results suggest a small UAG effect and challenge the view that the goals caused the GSEs to supply substantially more credit to high‐risk borrowers than they otherwise would have supplied during the subprime boom.     

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.     

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.     

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.     

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.     

Lender Steering in Residential Mortgage Markets

In this article, we examine the incentives for lenders to steer borrowers into piggyback loan structures to circumvent regulations requiring primary mortgage insurance (PMI) for loans with loan‐to‐value ratios (LTV) above 80%. Our empirical analysis focuses on propensity score‐matched portfolios of piggyback and single‐lien loans having the same combined LTV based on a full set of observed risk characteristics. Our results confirm that mortgages originated with the piggyback structure have much lower ex post default rates and faster prepayment speeds than corresponding PMI loans. We also find a significant causal effect of interstate banking deregulation on the growth of piggybacks in these years, confirming that the ex post performance gap is primarily driven by lender steering on the supply side and not by borrower self‐selection. We then perform a number of tests to explore different origination and execution channels of mortgage steering.     

The Performance of Low-Income and Minority Mortgages

This article analyzes the performance of low-income and minority mortgages (LIMMs) from a large sample of fixed-rate conventional conforming mortgages. We find that low-income borrowers are less likely to prepay when it is optimal, whereas black and Hispanic borrowers prepay more slowly than other borrowers, regardless of the option's value. After controlling for equity, credit history and some other variables, LIMMs default slightly more frequently and have about the same loss severity as other loans. Our results suggest that, for most yield curve situations, differences in LIMM prepayment behavior have little effect on pricing.     

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.     

A Tale of Two Tensions: Balancing Access to Credit and Credit Risk in Mortgage Underwriting

Over the years 2000–2007, mortgage market underwriting conditions eased in response to public policy demands for increased homeownership. This easing of acceptable credit risk in order to accommodate increased access to credit, when coupled with the unanticipated house price declines during the Great Recession, resulted in substantial increases in delinquencies and foreclosures. The response to this mortgage market crisis led to myriad changes in the industry, including tightened underwriting standards and new market regulations. The result is a growing concern that credit standards are now too tight, restricting the recovery of the housing market. Faced with this history, policy analysts, regulators and industry participants have been forced to consider how best to balance the tension inherent in managing mortgage credit risk without unduly restricting access to credit. Our research is unique in providing explicit consideration of this trade‐off in the context of mortgage underwriting. Using recent mortgage market data, we explore whether modern automated underwriting systems (AUS) can be used to extend credit to borrowers responsibly, with a particular focus on target populations that include minorities and those with low and moderate incomes. We find that modern AUS do offer a potentially valuable tool for balancing the tensions of extending credit at acceptable risks, either by using scorecards that mix through‐the‐cycle and stress scorecard approaches or by adjusting the cutpoint—more relaxed cutpoints allow for higher levels of default while providing more access, tighter cutpoints accept fewer borrowers while allowing less credit risk.     

Did Affordable Housing Legislation Contribute to the Subprime Securities Boom?

We use a regression discontinuity approach and present new institutional evidence to investigate whether affordable housing policies influenced the market for securitized subprime mortgages. We use merged loan‐level data on nonprime mortgages with individual‐ and neighborhood‐level data for California and Florida. We find no evidence that lenders increased subprime originations or altered loan pricing around the discrete eligibility cutoffs for the Government‐Sponsored Enterprises' (GSEs) affordable housing goals or the Community Reinvestment Act. Although we find evidence that the GSEs bought significant quantities of subprime securities, our results indicate that these purchases were not directly related to affordable housing mandates.     

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.     

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.