Posted Content•
Credit, Equity, and Mortgage Refinancings
01 Jul 1997-Federal Reserve Bank of New York Economic policy review (Federal Reserve Bank of New York)-Vol. 3, Iss: 2, pp 83-99
TL;DR: In this article, the authors consider the effect of individual homeowners' credit and property characteristics, such as personal credit ratings and changes in home equity, along with changes in mortgage interest rates, in the analysis and prediction of mortgage prepayments.
Abstract: Homeowners typically have the option to prepay all or part of the outstanding balance of their mortgage loan at any time, usually without penalty. However, unless homeowners have sufficient wealth to pay off the balance, they must obtain a new loan in order to exercise this option. Studies examining refinancing behavior are finding more and more evidence that differences in homeowners' ability to qualify for new mortgage credit, as well as differences in the cost of that credit, account for a significant part of the observed variation in that behavior. Therefore, individual homeowner and property characteristics, such as personal credit ratings and changes in home equity, must be considered systematically, along with changes in mortgage interest rates, in the analysis and prediction of mortgage prepayments. Early research into the factors influencing prepayments focused almost exclusively on the difference between the interest rate on a homeowner's existing mortgage and the rates available on new loans. This approach arose in part because researchers most often had to rely on aggregate data on the pools of mortgages serving as the underlying collateral for mortgage-backed securities (for example, see Schorin {1992}). More recent research, however, has broadened the scope of this investigation through the utilization of loan-level data sets that include individual property, loan, and borrower characteristics. This article significantly advances the literature on mortgage prepayments by introducing quantitative measures of individual homeowner credit histories to the loan-level analysis of the factors influencing the probability that a homeowner will refinance. In addition to credit histories, we include in the analysis changes in individual homeowner's equity and in the overall lending environment. Our findings strongly support the hypothesis that, other things being equal, the worse a homeowner's credit rating, the lower the probability that he or she will refinance. We also confirm the finding of other researchers that changes in home equity strongly influence the probability of refinancing. Finally, we provide evidence of a change in the lending environment that, all else being equal, has increased the probability that a homeowner will refinance. These findings are important from an investment risk management perspective because they confirm that the responsiveness of mortgage cash flows to changes in interest rates will also be significantly influenced by the credit and equity conditions of individual borrowers. Moreover, evidence overwhelmingly indicates that these conditions are subject to dramatic changes. For example, although the sharp rise in personal bankruptcies since the mid-1980s (Chart 1) partly reflects changes in laws and attitudes, it nonetheless suggests that credit histories for a growing segment of the population are deteriorating. Furthermore, home price movements, the key determinant of changes in homeowners' equity, have differed considerably over time and in various regions of the country. Indeed, in the early to mid-1990s home price appreciation for the United States as a whole slowed dramatically while home prices actually fell for sustained periods in a few regions (Chart 2). [Chart 1-2 ILLUSTRATION OMITTED] In short, as mortgage rates fell during the first half of the 1990s, many households likely found it difficult, if not impossible, to refinance existing mortgages because of poor credit ratings or erosion of home equity.(1) Consequently, the prepayment experience of otherwise similar pools of mortgage loans may vary greatly depending on the pools' proportions of credit- and/or equity-constrained borrowers. Our findings also contribute to an understanding of how constraints on credit availability affect the transmission of monetary policy to the economy (for example, see Bernanke {1993}). Fazzari, Hubbard, and Petersen (1988) and others have found that investment expenditures by credit-constrained businesses are especially closely tied to those firms' cash flows and are relatively insensitive to changes in interest rates, reflecting constraints on their ability to obtain credit. …
Citations
More filters
Posted Content•
TL;DR: In this article, the authors show that a financial market liberalization drives risk premia in both the housing and equity markets down, shifts the composition of wealth for all age and income groups towards housing, and leads to a short-run boom in aggregate consumption but a short run bust in investment.
Abstract: bond markets calibrated to match the increase in foreign ownership of U.S. Treasury and agency debt from 2000-2007 generates an increase in national price-rent ratios comparable to that observed in U.S. data over this period. Moreover, in a simulated transition for the period 2000-2009, the model generates a decline of greater than 16% in national house price-rent ratios in the two year period 2007 to 2009, driven by the economic contraction and by a presumed reversal of the financial market liberalization. A financial market liberalization drives risk premia in both the housing and equity market down, shifts the composition of wealth for all age and income groups towards housing, and leads to a short-run boom in aggregate consumption but a short-run bust in investment. By contrast, although an influx of foreign capital into the domestic bond market reduces interest rates, it increases risk premia in both the housing and equity markets. Finally, the model implies that procyclical increases in equilibrium price-rent ratios reflect expectations of lower future housing returns, not higher future rents.
437 citations
TL;DR: In this article, the authors simulate the U.S. housing market with and without equity extractions, and estimate the losses absorbed by mortgage lenders by valuing the embedded put-option in non-recourse mortgages.
Abstract: The confluence of three trends in the U.S. residential housing market - rising home prices, declining interest rates, and near-frictionless refinancing opportunities - led to vastly increased systemic risk in the financial system. Individually, each of these trends is benign, but when they occur simultaneously, as they did over the past decade, they impose an unintentional synchronization of homeowner leverage. This synchronization, coupled with the indivisibility of residential real estate that prevents homeowners from deleveraging when property values decline and homeowner equity deteriorates, conspire to create a “ratchet” effect in which homeowner leverage is maintained or increased during good times without the ability to decrease leverage during bad times. If refinancing-facilitated homeowner-equity extraction is sufficiently widespread - as it was during the years leading up to the peak of the U.S. residential real-estate market - the inadvertent coordination of leverage during a market rise implies higher correlation of defaults during a market drop. To measure the systemic impact of this ratchet effect, we simulate the U.S. housing market with and without equity extractions, and estimate the losses absorbed by mortgage lenders by valuing the embedded put-option in non-recourse mortgages. Our simulations generate loss estimates of $1.5 trillion from June 2006 to December 2008 under historical market conditions, compared to simulated losses of $280 billion in the absence of equity extractions.
117 citations
TL;DR: In this paper, the authors examined the performance of 30-year fixed rate owner occupied home purchase mortgages from February 1995 to the end of 1999 and compared nonprime and prime loan default and prepayment behavior.
Abstract: Although nonprime lending has experienced steady or even explosive growth over the last decade very little is known about the performance characteristics of these mortgages. Using data from national secondary market institutions, this paper estimates a competing risks proportional hazard model, which includes unobserved heterogeneity. The analysis examines the performance of 30-year fixed rate owner occupied home purchase mortgages from February 1995 to the end of 1999 and compares nonprime and prime loan default and prepayment behavior. Nonprime loans are identified by mortgage interest rates that are substantially higher than the prevailing prime rate. Results indicate that nonprime mortgages differ significantly from prime mortgages: they have different risk characteristics at origination; they default at elevated levels; and they respond differently to the incentives to prepay and default. For instance, nonprime mortgages are less responsive to how much the option to call the mortgage or refinance is in the money and this effect is magnified for mortgages with low credit scores. Tests also reveal that default rates are less responsive to homeowner equity when credit scores are included in the specification.
113 citations
TL;DR: In this article, an option-based hazard model of the competing risks of FHA mortgage termination was proposed, showing that the elevated default risks of loans originated among lower credit-quality and minority borrowers are more than offset by the damped prepayment speeds of those loans, so as to result in markedly lower loan termination probabilities among underserved borrowers.
Abstract: This paper estimates an option-based hazard model of the competing risks
of FHA mortgage termination. Results indicate that the elevated default
risks of loans originated among lower credit-quality and minority borrowers
are more than offset by the damped prepayment speeds of those loans, so
as to result in markedly lower loan termination probabilities among underserved
borrower groups. Those damped termination risks translate into
sizable reductions in risk premia to investors in simulated lower creditquality
mortgage pools. Empirical findings suggest that such pooling and
risk-based pricing of FHA-insured mortgages could serve to substantially
reduce housing finance costs among underserved borrowers, so as to advance
both their homeownership opportunities and related federal housing
policy objectives.
102 citations
TL;DR: This paper showed that financial considerations are the primary drivers of the refinance choice while homeowner characteristics have more influence on the move decision, 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.
Abstract: 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 the next decade.
92 citations
References
More filters
TL;DR: In this paper, the authors examine the importance of a financing hierarchy created by capital-market imperfections and find that investment is more sensitive to cash flow for the group of firms that are most likely to face external finance constraints.
Abstract: Most empirical models of investment rely on the assumption that firms are able to respond to prices set in centralized securities markets (through the "cost of capital" or "q"). An alternative approach emphasizes the importance of cash flow as a determinant of investment spending, because of a "financing hierarchy," in which internal finance has important cost advantages over external finance. We build on recent research concerning imperfections in markets for equity and debt. This work suggests that some firms do not have sufficient access to external capital markets to enable them to respond to changes in the cost of capital, asset prices, or tax-based investment incentives. To the extent that firms are constrained in their ability to raise funds externally, investment spending may be sensitive to the availability of internal finance. That is, investment may display "excess sensitivity" to movements in cash flow. In this paper, we work within the q theory of investment, and examine the importance of a financing hierarchy created by capital-market imperfections. Using panel data on individual manufacturing firms, we compare the investment behavior of rapidly growing firms that exhaust all of their internal finance with that of mature firms paying dividends. We find that q values remain very high for significant periods of time for firms paying no dividends, relative to those for mature firms. We also find that investment is more sensitive to cash flow for the group of firms that our model implies is most likely to face external finance constraints. These results are consistent with the augmented model we propose, which takes into account different financing regimes for different groups of firms. Some extensions and implications for public policy are discussed at the end.
4,123 citations
TL;DR: In this article, a new measure of goodness of fit for linear regression with dichotomous dependent variables is proposed, which can be interpreted intuitively in a similar way to R 2 in the linear regression context.
Abstract: The econometrics literature contains many alternative measures of goodness of fit, roughly analogous to R 2, for use with equations with dichotomous dependent variables. There is, however, no consensus as to the measures' relative merits or about which ones should be reported in empirical work. This article proposes a new measure that possesses several useful properties that the other measures lack. The new measure may be interpreted intuitively in a similar way to R 2 in the linear regression context.
374 citations
TL;DR: This article found that the average U.S. owner overestimates the value of his/her house by 6% and the average absolute error is 14% in the American Housing Survey.
278 citations
TL;DR: In this paper, the authors introduced a new option-theoretic analysis of the homeowners' decision to prepay a mortgage and showed that the seasoning process for mortgages depends on the same ratio, the coupon relative to the refinancing rate.
Abstract: Scott F . Richard and Richard Roll M ortgage-backed securities (MBSs) are increasingly a part of the financial scene. To assess their relative value and the value of their derivatives, it is essential to predict mortgage prepayments accurately. It is important to understand how mortgage pass-through securities will prepay in today’s interest rate environment as well as how prepayments will fluctuate as interest rates fluctuate. This paper introduces our latest work on prepayment modeling. Recognizing that work in this area is never completed, we feel nevertheless that our model includes certain innovations and attributes that extend the understanding of mortgage prepayments. We begin by analyzing the economic theory underlying a homeowner’s decision to prepay a mortgage. This option-theoretic analysis serves as the basis for our empirical model of prepayment rates. Three aspects of our model are novel. First, we measure the mortgagor’s refinancing incentive as the ratio of the mortgage coupon to the current refinancing rate, not as the difference between these two rates. This idea comes from our economic analysis of the mortgagor’s prepayment decision. Second, we show that the seasoning process for mortgages depends importantly on this same ratio, the coupon relative to the refinancing rate. In particular, premium mortgages season more rapidly than current coupon mortgages, which, in turn, season more rapidly than discount mortgages. Finally, we examine the tendency of premium mortgages to slow or “burn out” over time. We introduce a measure of premium burnout that depends on the entire interest rate history since the mortgage was issued. We try to provide sufficient details so that readers can understand how the model works. Examples in the figures explain the Goldman Sachs prepayment model, without bogging readers down with unnecessary mathematical detail. We also report a detailed summary of our model’s predictions in relation to actual prepayment data.
202 citations