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Mortgage contract choice in subprime mortgage markets

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  • Gregory Elliehausen
  • Min Hwang
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    Abstract

    The boom in the subprime mortgage market yielded many loans with high LTV ratios. From a large proprietary database on subprime mortgages, we find that choice of mortgage rate type is not linear in loan sizes. A fixed rate mortgage contract is a popular choice when loan size, measured by LTV ratio, is small. As LTV ratio increases, borrowers become more likely to choose adjustable rate mortgage contracts. However, when LTV reaches a certain level, borrowers start to switch back to fixed rate contracts. For these high LTV loans, fixed rate mortgages dominate borrowers' choices. We present a very simple model that explains this "nonlinear" pattern in mortgage instrument choice. The model shows that the choice of mortgage rate type depends on two opposing effects: a "term structure" effect and an "interest rate volatility" effect. When the loan size is small, the term structure effect dominates: rising LTV ratios making ARM loans less costly, and more attractive. However, when the loan size is large enough, the interest volatility effect dominates: rising LTV ratios making FRM loans less costly and preferable. We present strong empirical evidence in support of the model predictions.

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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2010-53.

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    Date of creation: 2010
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    Handle: RePEc:fip:fedgfe:2010-53

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    Keywords: Mortgage loans ; Subprime mortgage;

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    1. Sven Rady, 1998. "Boom In, Bust Out: Young Households and the Housing Price Cycle," FMG Discussion Papers dp310, Financial Markets Group.
    2. Ralph S.J Koijen & Otto Van Hemert & Stijn Van Nieuwerburgh, 2007. "Mortgage Timing," NBER Working Papers 13361, National Bureau of Economic Research, Inc.
    3. Newey, Whitney K., 1987. "Efficient estimation of limited dependent variable models with endogenous explanatory variables," Journal of Econometrics, Elsevier, vol. 36(3), pages 231-250, November.
    4. Matteo Iacoviello, 2005. "House Prices, Borrowing Constraints, and Monetary Policy in the Business Cycle," American Economic Review, American Economic Association, vol. 95(3), pages 739-764, June.
    5. David M. Harrison & Thomas G. Noordewier & Abdullah Yavas, 2004. "Do Riskier Borrowers Borrow More?," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 32(3), pages 385-411, 09.
    6. Sven Rady, 2001. "Housing Market Dynamics: on the Contribution of Income Shocks and Credit Constraints," FMG Discussion Papers dp375, Financial Markets Group.
    7. Posey, Lisa L. & Yavas, Abdullah, 2001. "Adjustable and Fixed Rate Mortgages as a Screening Mechanism for Default Risk," Journal of Urban Economics, Elsevier, vol. 49(1), pages 54-79, January.
    8. Brent Ambrose & Anthony Sanders, 2004. "Legal Restrictions in Personal Loan Markets," The Journal of Real Estate Finance and Economics, Springer, vol. 30(2), pages 133-151, November.
    9. Brent W. Ambrose & Michael LaCour-Little & Anthony B. Sanders, 2004. "The Effect of Conforming Loan Status on Mortgage Yield Spreads: A Loan Level Analysis," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 32(4), pages 541-569, December.
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    Cited by:
    1. Fred Furlong & Yelena Takhtamanova, 2012. "Did the housing boom affect mortgage choices?," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue nov5.

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