Household Finance
Mortgage
Jian ZHANG
Faculty of Business and Economics
University of Hong Kong
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Course Structure
Basic
Choices
Household
Balance Sheet
Related
Topics
◦ Consumption
◦ Consumer Behavior
◦ Saving
◦ Household Portfolio
◦ Investing
◦ Housing
◦ Mortgage
◦ Borrowing
◦ Payment
◦ Risk Management
◦ Financial Inclusion
and FINTECH
◦ Special Topic
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Outline
1. Mortgage Basic
2. Mortgage Calculation
3. Mortgage Decision and the Subprime Crisis
Mortgage Choice
Interest, Amortization and Payment
ARM vs FRM
Mortgage Refinancing
Mortgage Default
4. Subprime Crisis
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Mortgage Basic
Outline
1. Mortgage Basic
2. Mortgage Calculation
3. Mortgage Decision and the Subprime Crisis
Mortgage Choice
Interest, Amortization and Payment
ARM vs FRM
Mortgage Refinancing
Mortgage Default
4. Subprime Crisis
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Mortgage Basic
Mortgage
I A mortgage is a large long-term loan collateralized by the property
financed.
Obligations
Investment
risks
Lender
• Provision of capital for the
loan
• Borrower defaults
Borrower
• Make interest and capital
repayment
• Risk of losing the home
(default)
• Circumstances change to
jeopardize ability to repay
• For example, illness, loss of
job, business break down etc.
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Mortgage Basic
Mortgage
How does
each party
mitigate risks
Lender
• Collateral: lender can
repossess and liquidate
• Securitization to spread
default risks across
stakeholders
• Interest rates to
offset funding costs
Borrower
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Mortgage Basic
Legal Foundation
I In a mortgage loan, the borrower always conveys two documents to the
lender
1. a note
2. a mortgage (or deed of trust)
I The note details the financial rights and obligations between borrower
and lender and defines the exact terms and conditions of the loan
I e.g., whether a loan can be paid off early and at what cost, what fees can
be charged for late payments
I The mortgage pledges the property as security for the debt
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Mortgage Basic
The note - Interest Charges
I Interest rates can be fixed or variable
Ratemonth =
Stated rateannual
12
Interest Paymentmonth = Ratemonth × Beginning Balancemonth
Example
I Suppose that the contract rate is 6% and the balance on the first day of
January is $100,000
I The interest for January is: (6%/12) × $100, 000 = $500
I The $500 interest is payable on the first day of February
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Mortgage Basic
The note - Adjustable Rates
I This loan type is known as ARM (adjusted rate mortgage) in the
residential loan markets
I Index
I The “index rate” is a market-determined interest rate - the moving part
I U.S. Treasury rate or LIBOR
I Whenever there is a change in interest rate, home mortgage lenders
usually need to notify borrowers at least 30 days in advance.
I Margin
I There is a markup in the adjustable rate, called “margin”
I Determined by the lender.
I For standard ARM loans, the average margin is about 2.75%.
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Mortgage Basic
The note - Adjustable Rates
I Rate Caps
I Periodic cap: the cap that limits change in the interest rate from one
change date to the next.
I Overall cap: the cap that limits interest rate change over the life of the loan
I Teaser rate
I Many ARM loans are marketed with a temporarily reduced interest rate
I Example: the initial index plus margin implies a starting rate of 5.0
percent, but a teaser rate of 3.5 percent applies in the first year.
I Payment cap:some lenders offer ARM loans with a cap on payments
rather than on the interest rate
I For example, the payment in the initial year is $1,000 and the payment can
be capped at increases of no more than 5% in a single year, the maximum
payment in year 2 is $1,050.
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Mortgage Basic
The note - Payment
I Payments on standard mortgage loans are almost always monthly
I Most standard, fixed loans are level payment and fully amortizing
I zero balance at the maturity
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Mortgage Basic
The note - Payment
I Not every loan is fully amortizing
I partially amortizing: it pays down partially over the loan life and
requires an additional (large) payment of principal with the last
scheduled payment.
I non-amortizing: Only periodic (monthly) interest payments are made.
The principal payment is required at the maturity.
I negative amortization: scheduled payment is insufficient to pay all of
the accumulating interest so that some interest is added to the balance
I Example: if interest charges increase more than the payment cap, the
unpaid interest would be added to the original balance, causing the loan
balance to increase.
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Mortgage Basic
The note - Term
I Most loans have a definite term to maturity, usually stated in years(15-30
years)
I Balloon loan: a partially amortized loan and calls for a balloon payment
at the end
I Term for amortization: determines the payment, and the schedule of
interest and principal payments, just like a fully amortized loan
I Term to maturity: determines when the entire remaining balance on the
loan must be paid in full.
I Balloon loans are popular for income-generating property
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Mortgage Basic
Normal Mortgage: APR=3.63%, 2 years
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Mortgage Basic
Balloon Loan: APR=2%, 2 years
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Mortgage Basic
The note - Right of Prepayment
I If the note says nothing about the right of prepayment, the determination
of the right will depend on the law of the state.
I In recent years prepayment penalties have become more common in
larger home loans and subprime home mortgage loans
I Subprime loans: made to homeowners who do not qualify for standard
home loans
I Prepayment penalty is usually very severe for the first few years of the
loan, but declines in the latter half of the loan term
I A percentage of the remaining balance
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Mortgage Basic
The note - Late Fees and Personal Liability
I Late fees
I They are usually accessed on payments received after the 15th of the
month the payment is due
I Late fees are usually about 4-5% of the late monthly payment
I Personal liability
I For home loans, borrowers usually assume personal liability. That is, if
they fail to meet the terms of the note, they are in the condition of default,
and can be sued.
I These loans are called recourse loans because the lenders have legal
recourse in case of default.
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Mortgage Basic
The Mortgage or Deed of Trust
I The mortgage is a special contract by which the borrower (mortgagor)
conveys to the lender (mortgagee) a security interest in the mortgaged
property
I In general, the mortgage gives the lender the right to rely on the property
as security for the debt obligation defined in the note, but this right only
can be exercised in the event of default on the note
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Mortgage Basic
The Mortgage: Major Clauses
I Description of the property.
I Insurance clause
I requires a borrower to maintain property casualty insurance (against fire,
windstorm, etc), giving the lender joint control in the use of the proceeds
in case of major damage to the property
I Escrow clause
I requires a borrower to make monthly deposits into an escrow account for
property taxes, casualty insurance premiums, etc
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Mortgage Basic
The Mortgage: Major Clauses
I Acceleration clause: enables the lender to declare the entire loan balance
due and payable when the borrower defaults on the loan.
I Due-on-sale clause: gives the lender the right to accelerate the loan,
requiring the borrower to pay it off when the property is sold
I Hazardous substances clause and preservation and maintenance clause:
the borrower is prohibited from using or storing hazardous substances on
the property and is required to maintain the property in its original
condition
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Mortgage Basic
When Things Go Wrong
I Default: failure to meet the requirements of the note (and by reference,
the mortgage).
I Technique defaults: minor violations of the note that do not disrupt the
payments on the loan.
I Example: hazard insurance no longer good.
I These usually do not trigger legal actions
I Substantive defaults: when payments are missed, typically for 90 days
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Mortgage Basic
When Things Go Wrong
I Lenders may help borrowers improve their household financial
management
I credit counseling, a temporary reduction of payments
I Foreclosure: a legal process of terminating all claims of ownership by
the borrower, and all liens inferior to the foreclosing lien.
I The lenders can bring about free and clear sale of the property to recover
the outstanding indebtedness
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Mortgage Basic
When Things Go Wrong
I The ultimate recourse of the lender
I Costly and time consuming
I Court-supervised
I One concern in foreclosure is the presence of superior liens
I Liens have priority according to their date of creation, with earlier liens
being superior
I Government liens are automatically superior to any private lien
Example
If a property with a first mortgage loan of $100,000 and a second mortgage
loan of $30,000 brings net proceeds of $110,000 from a foreclosure sale, the
first mortgagee would receive full satisfaction of $100,000 while the second
mortgagee would receive only $10,000
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Mortgage Basic
Regulations
I Few business are regulated more extensively than home mortgage
lending
I Determine criteria for evaluating home loan applicants
I Stipulate extensive disclosures in the origination of home loans
I Equal Credit Opportunity Act (ECOA) in 1974
I prohibits discrimination in lending practices on the basis of race, color,
religion, national origin, sex, marital status, age, familial status, disability
I Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010
I Altering the character of home loans by imposing a standard of “ability to
repay” and by rewarding an even stronger standard called Qualified
Mortgages
I Creating the Consumer Financial Protection Bureau (CFPB).
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Mortgage Basic
Mortgage Menu
I Conventional mortgage loans
I (Fixed-rate) level-payment mortgages (FRMs)
I Adjustable rate mortgage (ARMs)
I Government-sponsored mortgage loans
I Federal Housing Administration(FHA)-insured loans
I VA(Veterans Affairs)-guaranteed loans
I Other mortgage products
I Home equity loan
I Interest-only mortgage
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Mortgage Basic
Conventional mortgage loans
I Definition: Any standard home loan that is not insured or guaranteed by
an agency of the U.S. government
I Conventional mortgages can be either fixed rate (FRMs) or adjustable
rate (ARMs).
I over 90 percent of all conventional loans are fixed-rate in 2016
I The primary and secondary mortgage market
I Primary mortgage market is the loan origination market, in which
borrowers and lenders come together
I Mortgage originators can either hold the loans in their portfolios or sell
them in the secondary mortgage market (Fannie Mae and Freddie Mac)
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Mortgage Basic
Government-Sponsored mortgage loans
I FHA-insured loans
I The federal housing administration was established in 1934 to stabilize the
housing industry.
I FHA sells mortgage insurance to low-income households.
I FHA mortgage insurance covers any lender loss after foreclosure and
conveyance of title of the property to the U.S. Department of Housing and
Urban Development (HUD).
I VA-guaranteed loans
I The Department of Veterans Affairs provides VA-guaranteed loans that
help veterans obtain home mortgage loans with favorable terms
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Mortgage Basic
Home Equity
I Home equity is the difference
between the fair market value and
the outstanding liens on the
property
I Home equity increases when
I Borrower makes payments
against mortgage balance
I Property value appreciates.
I Ways of accessing home equity.
I
I
I
I
Selling the property
Refinancing the property
Home equity credit
Reverse mortgages
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Mortgage Basic
Home Equity Credit
I Home equity credit, where the home equity serves as the collateral, is
one way homeowners can access access capital
I Home equity credit constitute a significant fraction of US household
leverage from 2002 to 2006 and defaults from 2006 to 2008.
I Home equity credit is subordinated to the first mortgage
I In the event of a foreclosure, the collateral property will be sold and the
first mortgage has to be paid in full before the home equity lender can
recover.
I Tax benefits to home equity credit: under the US tax law, interest
expenses on home equity loans can be deducted from taxable income
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Mortgage Basic
Two Types of Home Equity Credit
I Home Equity Line of Credit (HELOC)
I Money is borrowed as it is needed, drawn against a maximum amount that
is established when the account is opened
I The maximum home equity loan is the amount that increases total
mortgage debt up to that Loan-to-Value (LTV) limit (75% or 80%)
Example
If a house is appraised at $200,000, has a $100,000 mortgage balance, and the
lender sets a 75 percent LTV ratio, a homeowner could borrow $150,000,
minus the $100,000 existing debt, or an additional $50,000.
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Mortgage Basic
Two Types of Home Equity Credit
Home equity loans
I A home equity loan is a
closed-end loan with fixed
interest rates
I Monthly instalment
repayments of interest and
principal.
I Second Mortgage
HELOC
I A revolving credit facility
with variable rate
I The line of credit remains
open until its term ends
I Similar to other revolving
credit line(i.e. credit card) but
is secured by asset
I Substitute for consumer credit, offers tax deductibility on interest
expense and reduces monthly debt service payments by lengthening loan
maturities.
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Mortgage Basic
Home Equity - Reverse Mortgages
I Reverse mortgages allow (elder) home-owners to borrow against home
equity and receive a lump sum or monthly disbursement
I In contrast to home equity credit, reverse mortgages do not require
repayment until the borrower dies, permanently moves out or sells the
home.
I Demand for reverse mortgage products is generally low
I The seemingly low take-up rate of reverse mortgage products can be
improved with more targeted marketing
I Hanewald, Bateman, Fang and Wu (2019) suggest by reframing how the
mortgage payment can be used, older home owners and adult children
both show interest in reverse mortgage products.
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Mortgage Basic
Interest-only (IO) Loans
I The true I-O mortgage
I No monthly principal payment, and the balance remains at the original
amount
I Suppose you borrow $10,000 at 12% opportunity with a 12-month
duration. You make interest-only payments
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Mortgage Basic
Fully Amortized Loan:Payment Schedule
I If the loan is fully amortized
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Mortgage Calculation
Outline
1. Mortgage Basic
2. Mortgage Calculation
3. Mortgage Decision and the Subprime Crisis
Mortgage Choice
Interest, Amortization and Payment
ARM vs FRM
Mortgage Refinancing
Mortgage Default
4. Subprime Crisis
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Mortgage Calculation
Mortgage Calculation - Roadmap
I Basic Computations
I Monthly payments
I Loan balance
I Effective Borrowing Cost (EBC)
I Fixed-Rate and Adjustable Rate Mortgages
I Refinancing
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Mortgage Calculation
Basic Computations
I Analytics of level-payment loans are a straight-forward application of
time-value tools.
I Loan Balance at origination
I The present value of the future payments, discounted at the contract
interest rate
I Example: A 30-year, fixed-rate, FRM mortgage. The quoted interest rate
is 6%. The monthly payment is $1,000. What is the loan amount?
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Mortgage Calculation
Basic Computations
I We always can reverse the logic to find the payment for that loan amount.
I Payment
I A level-payment loan of $100,000 for 15 years at an annual interest rate of
6 percent. What is the loan amount?
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Mortgage Calculation
Basic Computations
I Loan Balance at any time
I Present value of the remaining payments, discounted at the contract
interest rate.
I Example: What is the remaining balance at the end of five years (60
months) on the 15-year loan discussed in the previous slides?
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Mortgage Calculation
Basic Computations
I Effective Borrowing Cost
I The implied IRR (yield) from the borrower’s perspective.
I When a mortgage loan is created, the borrower must pay certain up-front
expenses, including discount points and closing costs (i.e. title insurance,
appraisal fee) etc.
I Example: Suppose we have a loan with payments of $1,000 per month, a
term of 360 months, and an annual contract interest rate of 7 percent
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Mortgage Calculation
Basic Computations
I Effective Borrowing Cost
I Example: Total closing expenses of $8,000 ($5,307.57 in discount points,
plus $2,692.43 in other closing expenses not paid to the lender).
I Therefore, the borrower will receive $150,307.57 (the “face” value of the
loan) less $8,000, for net loan proceeds of $142,307.57, after paying all
the up-front expenses.
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Mortgage Calculation
Basic Computations
I Effective Borrowing Cost with prepayment
I Example: Suppose that our example loan is expected to be paid off at the
end of seven years. What does this prepayment do the EBC?
I The loan balance at the end of seven years, equal to the present value of
the remaining 276 payments
I In general, whenever a lender charges “up-front” points or other fees on a
loan, the earlier the loan is paid off, the higher is the EBC
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Mortgage Calculation
Usual up-front financing costs
I Discount points.
I Loan origination fee (e.g., 1% of the loan amount).
I Loan application and document fees ($200-$700).
I Appraisal ($250-$400).
I Credit check ($35-$75).
I Title insurance (0.5-1% of the loan).
I Mortgage insurance (>2% of the loan if pay up-front).
I Recording fee ($40-$200).
I Survey costs ($200-$300).
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Mortgage Calculation
Basic Computations
I Discount Points, Holding Periods and Effective Borrowing Cost
I Example: consider a 6.00 percent, 30-year, $200,000 level-payment
mortgage with a monthly payment of $1,199.10 (holding the contract rate
constant)
I Assume up-front financing costs, including all costs paid to the lender and
third parties except discount points, equal $3,000.
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Mortgage Calculation
Adjustable Rate Mortgage
I The interest rate on ARMs originated must be tied to a published index
of interest rates that is beyond the control of the lender.
I Periodic cap: the cap that limits change in the interest rate from one
change date to the next.
I Overall cap: the cap that limits interest rate change over the life of the
loan.
I Teaser rate: many ARM loans are marketed with a temporarily reduced
interest rate.
I One of the most popular ARMs is 1-year ARM based on a 30-year
amortization; that is, the initial contract rate remains in effect for 1 year
and adjusts annually thereafter
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Mortgage Calculation
Basic Computations
I Adjustable Rate Mortgage with Teaser Rate but No Caps
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Mortgage Calculation
Refinancing
I The borrower may refinance after interest rate falls.
I Whether to refinance is a very complex investment decision because
refinancing is not a one-time decision.
I You can refinance later (say, 1 year later) when interest rate could be
lower, instead of doing it today even though doing it today seems to be a
good deal compared with the existing loan.
I Timing option.
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Mortgage Calculation
Refinancing
Example
I Suppose that Alan has an existing loan with a remaining term of 15
years, a remaining balance of $100,000, and an interest rate of 7%. The
existing monthly payment is $898.83.
I Alan can refinance the loan for $100,000, the same 15 years, for 5%. But
the up-front refinancing costs (fees) are 5% (usually 3-9%) of the loan
amount, i.e., $5,000.
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Mortgage Calculation
Refinancing
Example
I If refinancing, the monthly rate is 5 / 12 = 0.4167%.
I Suppose the $5000 fee is not amortized. The monthly payment is: 180
N; 0.4167 I/Y; 100000 PV; CPT PMT → -790.81.
I The reduction in monthly payment: 898.83 - 790.81 = $108.02.
I Suppose that Alan can earn 6% on the $108.02 saving.
I If Alan expects to sell his house in 8 years, the PV of the expected
benefits of refinancing is: 96 N; 0.5 I/Y; 108.02 PMT; CPT PV =
-8,219.8055.
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Mortgage Calculation
Refinancing
Example
I The up-front refinancing costs (fees) are 5% (usually 4-9%) of the loan
amount, i.e., $5,000.
I Suppose that Alan has a 20% marginal income tax rate.
I The NPV of refinancing after tax is:
(8219.8055 × (1 − 20%)) − 5000 = $1, 575.884
I NPV > 0, so refinancing is not a bad idea
I We focus on NPV after tax because mortgage interest payments are tax
deductible; the existing loan has higher interest expense and higher tax
benefits than the new (refinancing) one
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Mortgage Calculation
Optimal Refinancing
I A widely used rule of thumb by practitioners and news media is that:
refinance when the interest rate spread between existing loan and a new
loan reaches about 2%.
I Of course, this rule of thumb is very rough
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Mortgage Decision and the Subprime Crisis
Outline
1. Mortgage Basic
2. Mortgage Calculation
3. Mortgage Decision and the Subprime Crisis
Mortgage Choice
Interest, Amortization and Payment
ARM vs FRM
Mortgage Refinancing
Mortgage Default
4. Subprime Crisis
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
Interest-only and Negative Amortization Mortgages
I Bright side
I Minimize mortgage payments and alleviate liquidty constraints for
borrowers.
I Optimal when there is mortgage interest tax deduction (Piskorski and
Tchistyi, 2010)
I Dark side
I For the borrower: Substantially increase the interest paid over the lifetime
I For the borrower: The ballon payment at the maturity causes refinancing
risk
I For the provider: Higher default risk arising from the lack of demortization
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
Higher fee now vs future interest payment
I “Mortgage discount points contract”
I The points allow you to pay more in closing costs in exchange for a lower
mortgage rate
I Essentially an investment project
I Investing in discount points is equivalent to trading an upfront investment
for a reduction in interest rate(i.e. future positive cash flows)
I A great way to save money over the life for borrowers who stay in the
mortgage longer
I Unknown investment horizon
I Sell the house
I Refinance the loan
I Default on the mortgage
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
Higher fee now vs future interest payment
Example
I A 30-year, fixed-rate mortgage in the amount of $200,000
I The borrower bought two discount points, with each costing 1 percent of
the loan principal, or $2,000.
Payment
Loan principal
$200,000
Interest rate
4%
Discount points
None
Monthly payment
$954
Interest total
$144,016
$200,000
3.5%
$4,000
$898
$123,336
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
Higher fee now vs future interest payment
I By buying two points for $4,000 upfront, the borrower’s interest rate
shrank to 3.5 percent, lowering their monthly payment by $56, and
saving them $20,680 in interest over the life of the loan
I What is the break-event point?
$4, 000/$56 = 71 months
I The borrower would have to stay in the home 71 months, or almost six
years, to recover the cost of the discount points
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
Investing in the “Points”
I The investment is more attractive when
I the borrower’s horizon is longer
I alternative investment opp. are weak
I In absence of personal taxes, the NPV of one percentage point1
T
NPV(1% of loan balance) = −B0 + ∑
t=1
1
12 δ Bt−1
(1 + r)t
I The borrower invests one percentage point of the balance(B0 )
I T monthly interest payment reduction, calculated as the
beginning-of-period balance (Bt−1 ) multiplies by the interest reduction
I Invest only when they have a positive NPV
1 The
borrower receives a reduction δ percentage points from annual interest rate for investing one percent point of the balance
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
Financial Mistakes?
I Evidence for consumer mistakes (Agarwal, Ben-David and Yao,2017)
I The point taker on average lose out by $700.
I They tend to be less educated and financially savvy
I Retail products are often quite complex and the average household lack
the necessary knowledge or sophistication to understand and choose
optimally
I The role of supply-side: Banks seem to affect household’s choice
through
I Pricing: making mortgage features shrouded
I “Steering” customers towards certain products
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
ARM vs FRM: Cross Country Variation
I FRMs are popular in Germany and the US
I ARMs are used widely in Australia, Ireland, UK and Southern Europe
(Campbell, 2013).
I Fixed-rate vs LPR (Loan Prime Rate) in China
I The policy: Borrowers choose between sticking to previous older
fixed-rate agreements and shifting to the LPR by Aug 31,2020
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
FRM or LPR?
I 5-year loan prime rate decreased from 4.85% in Aug 2019 to 4.65% in
Aug 20202
2 http://www.chinamoney.com.cn/chinese/bklpr/
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
FRM or LPR?
Example
Mortgage amount of 1 Million RMB, 30-year maturity (5-year LPR)
Interest Rate(%)
4.85
4.8
4.75
4.65
4.55
Payment
Monthly Payment
5276.9
5246.65
5216.47
5156.37
5096.61
Monthly Saving
30.25
60.43
120.53
180.29
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
Trade-off between risks and costs
I Campbell and Coco(2003)3 consider the optimal consumption and
mortgage choices of a finitely lived investor with risky labor income
(non-tradable)
I FRM - wealth risk
I Real capital value of FRM is highly sensitive to inflation.
I Decline in inflation is the principal concern
I Refinancing can be a option for switching to a low-rate contract, but it
incurs transaction costs and limited by borrower’s credit profile
I ARM - short-term income risk
I Total constant real payment over the lifetime
I Monthly payment subject to short-term variability
I Binding in states of low-income and low house price
I Saving are exhausted
I Home equity falls below the minimum to take out a second loan
3 Campbell, J.Y. and Cocco, J.F., 2003. Household risk management and optimal mortgage choice. The Quarterly Journal of Economics,
118(4), pp.1449-1494.
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
Individual Variation
I Past experience (i.e. inflation)
I Individuals who have experienced higher inflation in the past prefer FRMs
over ARMs as they expect higher future inflation and thus higher nominal
interest rates (Botsch and Malmendier, 2020)
I Strong positive cross-sectional relationship between the average ARM
share and the historical level of inflation volatility (Campbell, 2013)
I Weimar Republic hyperinflation:
A loaf of bread in Berlin that cost
around 160 Marks at the end of
1922 cost 200,000,000,000 Marks
by late 1923
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
Adaptive expectation to project future rate4
I With an FRM,mortgage payments are constant and linked to the
long-term interest rate at the time of origination.
I With an ARM, future ARM payments will depend on future short-term
interest rates not known at origination
I Household uses an average of short-term interest rates from the recent past
I The decision rule is based on the difference between the long-term
interest rate and the recent average of short-term interest rates
4 Koijen,
R.S., Van Hemert, O. and Van Nieuwerburgh, S., 2009. Mortgage timing. Journal of Financial Economics, 93(2), pp.292-324.
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
Adaptive expectation to project future rate
I The observed ARM share has a correlation of 81% with the difference
between the five-year Treasury yield and the three-year moving average
of the one-year Treasury yield in the aggregate time series
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Mortgage Decision and the Subprime Crisis
Mortgage Choice
Impact of Mortgage choice of FRM and ARM
I Increased sensitivity to interest rate shocks (i.e. monetary policy
transmission)
I Mortgage markets with more ARMs are more vulnerable to policy rate
changes
I In the UK, widespread usage of ARMs saw the country to severe liquidity
squeeze when mortgage rates rose (Chinloy, 1995).
I Greater prevalence of ARM lead to be more responsive policy changes
from monetary policy, as ARMs lead to higher pass-through to households
I Greater consumption response
I During the financial crisis, regions in the US that have higher
concentration of ARM relative to FRM experienced a larger increase in
consumption when interest rates declined (Di Maggio, Kermani and
Ramcharan, 2014)
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Mortgage Decision and the Subprime Crisis
Mortgage Refinancing
Mortgage Refinancing
Concept Check
I Mortgage refinancing
refers to the process of
paying off an existing
loan and replacing it with
a new one
I Especially relevant for
those with FRM
I Allows borrowers to
benefit from interest
rate decline
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Mortgage Decision and the Subprime Crisis
Mortgage Refinancing
Reasons why homeowners refinance
I Obtain a lower interest rate
I Most popular reason, also known as a “rate-and-term” refinance
I Tap into home equity to finance a large purchase/consolidate high-cost
debt
I Cash-out refinance can help improve CFs if you have a hefty amount of
high-interest debt on credit cards or personal loans
I Shorten mortgage term
I Convert ARM to a FRM or vice versa
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Mortgage Decision and the Subprime Crisis
Mortgage Refinancing
Optimal Refinancing Rule
I The advisory services offer the break-even PV rule as the only
theoretical benchmark
I only refinance if you can recoup the closing costs of refinancing in
reduced interest payments
I Optimal refinancing occurs when
Interest saved by refinancing = Refinancing costs
I Two types of errors
I Error of commission: refinancing at a rate that is not sufficiently below the
initial mortgage rate
I Error of omission: failing to refinance at the optimal time
I The optimal refinancing is the solution to an optimal stopping problem
I Fixed refinancing cost to be incurred at the point of refinancing
I A stochastic interest rate
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Mortgage Decision and the Subprime Crisis
Mortgage Refinancing
Optimal Refinancing Rule
I Option Value of Refinancing should also be accounted for
I The Correct Optimal Refinancing Rule
Interest saved by refinancing =
Refinancing costs +
Option value of refinancing
I A loss is incurred from following the PV rule, which is equal to the
option value of the ability to refinance (Agarwal, Driscoll and Laibson,
2013)5
5 Agarwal, S., Driscoll, J.C. and Laibson, D.I., 2013. Optimal mortgage refinancing: A closed?form solution. Journal of Money, Credit and
Banking, 45(4), pp.591-622.
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Mortgage Decision and the Subprime Crisis
Mortgage Refinancing
Optimal Refinancing Rule
I Closed-form refinancing rule: refinance when the current rate falls below
the original rate by
1
[τ + W(−exp(−τ))]
φ
I The optimal refinancing solution depends on
I
I
I
I
The discount rate
Sandard deviation of the mortgage rate
Tax-adjusted refinancing cost
Remaining value of the mortgage, and the marginal tax rate
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Mortgage Decision and the Subprime Crisis
Mortgage Refinancing
The Reality
I Many households fail to refinance optimally despite large financial
savings.The total present discounted value of the forgone savings was
approximately $11,5006
6 (Campbell,
Jackson, Madrian and Tufano, 2011;Keys, Pope and Pope, 2016)
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Mortgage Decision and the Subprime Crisis
Mortgage Refinancing
What Impedes Optimal Refinancing? - Constraints
I Poor credit condition
I Those with poor credit history
I Unemployment
I A fall in income or the value of the collateral will make it difficult to
qualify for a new mortgage (Archer, Ling and McGill, 1996).
I Equity position
I Low equity position in the property are often blocked from obtaining
replacement financing to prepay their existing mortgage (Peristiani,
Bennett, Monsen, Peach and Raiff, 1997).
I Decrease in property value
I When adverse economic shocks cause property values to decrease, the
negative impact on the collateral makes it impossible for some home
owners to obtain new mortgages (Caplin, Freeman and Tracy, 1997).
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Mortgage Decision and the Subprime Crisis
Mortgage Refinancing
Why Impedes Optimal Refinancing? - Psychological Costs
I Two sources of inaction in the mortgage refinancing (Andersen et al.,
2019)7
I Time-dependent inaction
I Refinancing takes place at periodic intervals, missing intermediate low rate
I Observed in older households with lower income, education and wealth
I State-dependent inaction
I Refinancing takes place only when the incentive is high enough
I Popular in middle-aged households with high income and wealth
7 Andersen, S., Campbell, J.Y., Nielsen, K.M. and Ramadorai, T., 2020. Sources of inaction in household finance: Evidence from the
Danish mortgage market. American Economic Review, 110(10), pp.3184-3230.
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Mortgage Decision and the Subprime Crisis
Mortgage Default
Mortgage Default
A mortgage default happens when
I Borrowers cannot keep up with mortgage payments
I Lenders choose to foreclose such that the total amount of the loan is
immediately due
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Mortgage Decision and the Subprime Crisis
Mortgage Default
Predictors of mortgage default
I Economic Conditions
I Job loss by household head has an equivalent effect on likelihood of
default as a 35% decline in home equity
I Negative equity factor and illiquidity, measured by high credit card
utilization, are significantly associated with mortgage default, with both
factors interacting with each other.
I Credit Score
I Borrowers with low or no documentation(subprime mortgages) are 1.8
and 2.4 times more likely to default than those who provide
documentation of income and assets
I Loan-to-value ratios
I An increase in loan-to-value ratio from 75% to 125% also increases the
probability of default by two and seven percentage points for high and low
residual income borrowers respectively (Gerardi, Herkenhoff, Ohanian
and Willen ,2018)
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Mortgage Decision and the Subprime Crisis
Mortgage Default
Strategic defaults
I Occur when consumers have the ability to pay but default because the
home value have fallen below their loan amounts
I Strategic mortgage defaults account for 38% of all defaults. (Gerardi et
al, 2018)
I Strategic default rate rises very
sharply at higher Vantage credit
scores
I 2007 borrowers strategically
defaulting much more often than
2004 borrowers
I Prices were rising rapidly in
2004 whereas they were falling
in nearly all markets by 2007
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Subprime Crisis
Outline
1. Mortgage Basic
2. Mortgage Calculation
3. Mortgage Decision and the Subprime Crisis
Mortgage Choice
Interest, Amortization and Payment
ARM vs FRM
Mortgage Refinancing
Mortgage Default
4. Subprime Crisis
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Subprime Crisis
Subprime Crisis
I Widespread damage motivated extensive research into factors
contributing to the crisis.
I Theories of why credit markets malfunction
I
I
I
I
Rapid expansion of credit (Mian and Sufi, 2009)
Illiquidity in real estate (Elul et al, 2010)
Belief house prices will keep rising (Adelino et al, 2016; Foote et al, 2016)
Technology and use of credit scoring systems significantly reduced the
time and expense to evaluate the risk profiles of borrowers.
I Debt securitization.
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Subprime Crisis
Subprime Crisis
I The US subprime crisis affected the local economy through borrowers,
investors in the housing and financial markets
I The main difference between prime and subprime mortgages lies in the
risk profile of the borrower and the underwriting criteria.
I Subprime mortgages are
I More common in areas with rising house prices (Mayer and Pence, 2008).
I Present higher prepayment risk (Pennington-Cross, 2003)
I After origination, subprime loans are typically packaged and sold to
investors by private issuers where they do not retain default risk after Mortgage-Backed Security.
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Subprime Crisis
Secondary Mortgage Market
I The need for the secondary mortgage market
I Originators, such as mortgage banking companies, could sell mortgages
and thereby replenish funds with which new loans could be originated.
I Facilitate a geographic flow of funds, thereby allowing lenders located in
regions with excess demand for housing and mortgage financing to sell
mortgages to regions with a surplus of savings
I Two ways for originators to maintain a flow of new mortgage
originations
I Direct Sale Programs: sell mortgages directly to Fannie Mae, Freddie
Mac, or other private entities.
I Securitization: Place mortgages in pools and sell securities of various
types, using the mortgages in these pools as collateral
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Subprime Crisis
Mortgage-backed security (MBS)
Concept Check
A mortgage-backed security (MBS) is a type of asset-backed security which is
secured by a mortgage or collection of mortgages
I The mortgages are aggregated and sold to a group of individuals
I The shares of MBSs are not identical but rather issued as tranches
(French for "slices"), each with a different level of priority in the debt
repayment stream, giving them different levels of risk and reward
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Subprime Crisis
Mortgage-backed security (MBS)
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Subprime Crisis
Subprime Crisis: time line
I Early signs of the weakness in the real estate market in the 1990s
I Between 1998 and 2000, there was a downturn in FRM subprime
originations due to
I Delinquent payments, loan defaults from earlier subprime loans.
I The spillover into the secondary market caused MBS prices to drop and
investors to shun the high-risk MBS tranches.
I 1997 Asian financial crisis increased the cost of borrowing thereby
negatively affecting loan originations.
I In this period, some subprime originators failed, others merged and were
acquired
I This led to consolidation in the subprime industry in 2000 where it
became dominated by large firms
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Subprime Crisis
Subprime Crisis: time line
I After 2000, subprime lenders learned from the bad experience and
became focused on the more credit worthy borrowers (with higher credit
scores)
I Over this period, ARM borrowers had generally lower credit scores than
FRM borrowers (Chomsisengphet and Pennington-Cross, 2006)
I Loans that presented more risk to the lenders had larger down-payments or
lower loan-to-value ratios
I However, in later years, difference in loan-to-value ratios between the
least risky and riskiest loans became wider
I After financial conditions weakened, things started to fall apart in the
second half of 2007
I Between 2007 and 2017, an estimated six million foreclosures were
completed, with 25% of affected home owners previously owning
multiple homes
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Subprime Crisis
Mortgage and housing market
Mortgage market and housing market fueled one another
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Subprime Crisis
Post Crisis Response
I The subprime crisis resulted in
I Collapse of MBS
I Insolvency of financial institutions
I Extensive foreclosures (Beshears, Choi, Laibson and Madrian, 2018).
I It triggered a major rethink of the responsibilities of stakeholders in the
financial system.
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Subprime Crisis
Home Affordable Modification Program (HAMP)
I In order to stem significant negative externalities, the US government
provided financial incentives to lenders to renegotiate distressed
residential mortgages
I The underlying assumption of the HAMP is enhancing mortgage
affordability will reduce default
I Offer homeowners who are at risk of foreclosure reduced monthly
mortgage payments that are affordable and sustainable over the long-term
I It reached only one third of the targeted households. The shortfall was
due to
I Limitations in pre-existing organizational capacity
I Information asymmetry between borrowers and lenders
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Subprime Crisis
Home Affordable Refinancing Program (HARP)
I Government-sponsored enterprises (GSEs) provided credit guarantee on
refinancing of loans exceeding the usual loan-to-value ratio of 80
I Initial limit was capped at 105%
I Later increased to 125% by 2009.
I Although the program was well advertised, the muted response to HARP
was due to lack of competitive pressure on the lenders who had the
incentive to charge higher rates
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Subprime Crisis
Could the next housing bubble burst be in China?
I Fang, Gu, Xiong and Zhou (2016)8 argue that a financial crisis in China
is unlikely due to
I High down-payment on mortgage loans that are typically at 40%.
I Comparable growth of households disposable income that match rising
house prices
I Generally low participation by low-income households in the housing
market
I Expectations of continued growth in household income, amongst
households, indicating that financial burdens from mortgage are
temporary.
8 Fang, H., Gu, Q., Xiong, W. and Zhou, L.A., 2016. Demystifying the Chinese housing boom. NBER macroeconomics annual, 30(1),
pp.105-166.
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Subprime Crisis
Could the next housing bubble burst be in China?
I Possibly following a different path?
I Policy of Three red lines address debt build-up in real estate sector
I Liabilities (ex advanced proceeds) to Total Assets less than 70%
I Net Debt to Equity less than 100%
I Cash-to-short-term debt more than 1 ×
I If the developers fail to meet one, two, or all of the “three red lines”,
regulators would then place limits on the extent to which they can grow
debt
Color
Green
Yellow
Orange
Red
Number of Breach
0
1
2
3
Allowed Debt Growth
15%
10%
5%
0%
I China Evergrande Group’s recent tumble is a wake-up call
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Subprime Crisis
The three red lines
I Compliance of major developers as of 2020
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Subprime Crisis
Contagion in the economy system
I Spillover effects on the whole economy
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