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Payment changes and default risk: theimpact of refinancing on expected credit losses

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  • Joseph Tracy
  • Joshua Wright

Abstract

This paper analyzes the relationship between changes in borrowers' monthly mortgage payments and future credit performance. This relationship is important for the design of an internal refinance program such as the Home Affordable Refinance Program (HARP). We use a competing risk model to estimate the sensitivity of default risk to downward adjustments of borrowers' monthly mortgage payments for a large sample of prime adjustable-rate mortgages. Applying a 26 percent average monthly payment reduction that we estimate would result from refinancing under HARP, we find that the cumulative five-year default rate on prime conforming adjustable-rate mortgages with loan-to-value ratios above 80 percent declines by 3.8 percentage points. If we assume an average loss given default of 35.2 percent, this lower default risk implies reduced credit losses of 134 basis points per dollar of balance for mortgages that refinance under HARP.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 562.

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Date of creation: 2012
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Handle: RePEc:fip:fednsr:562

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Keywords: Adjustable rate mortgages ; Mortgages ; Default (Finance) ; Risk ; Credit;

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References

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  1. Anthony Pennington-Cross & Giang Ho, 2010. "The Termination of Subprime Hybrid and Fixed-Rate Mortgages," Real Estate Economics, American Real Estate and Urban Economics Association, American Real Estate and Urban Economics Association, vol. 38(3), pages 399-426.
  2. Bruce D. Meyer, 1988. "Unemployment Insurance And Unemployment Spells," NBER Working Papers 2546, National Bureau of Economic Research, Inc.
  3. Qi, Min & Yang, Xiaolong, 2009. "Loss given default of high loan-to-value residential mortgages," Journal of Banking & Finance, Elsevier, vol. 33(5), pages 788-799, May.
  4. Caplin, Andrew & Freeman, Charles & Tracy, Joseph, 1997. "Collateral Damage: Refinancing Constraints and Regional Recessions," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 29(4), pages 496-516, November.
  5. Brueckner, Jan K & Follain, James R, 1988. "The Rise and Fall of the ARM: An Econometric Analysis of Mortgage Choice," The Review of Economics and Statistics, MIT Press, vol. 70(1), pages 93-102, February.
  6. Richard K. Green & James D. Shilling, 1997. "The Impact of Initial-Year Discounts on ARM Prepayments," Real Estate Economics, American Real Estate and Urban Economics Association, American Real Estate and Urban Economics Association, vol. 25(3), pages 373-385.
  7. Brent W. Ambrose & Michael LaCour-Little & Zsuzsa R. Huszar, 2005. "A Note on Hybrid Mortgages," Real Estate Economics, American Real Estate and Urban Economics Association, American Real Estate and Urban Economics Association, vol. 33(4), pages 765-782, December.
  8. Sumit Agarwal & Gene Amromin & Itzhak Ben-David & Souphala Chomsisengphet & Douglas D. Evanoff, 2011. "Market-based loss mitigation practices for troubled mortgages following the financial crisis," Working Paper Series, Federal Reserve Bank of Chicago WP-2011-03, Federal Reserve Bank of Chicago.
  9. Foote, Christopher L. & Gerardi, Kristopher & Willen, Paul S., 2008. "Negative equity and foreclosure: Theory and evidence," Journal of Urban Economics, Elsevier, vol. 64(2), pages 234-245, September.
  10. Yongheng Deng & John M. Quigley & Robert Van Order, 2000. "Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options," Econometrica, Econometric Society, Econometric Society, vol. 68(2), pages 275-308, March.
  11. Andrew Haughwout & Ebiere Okah & Joseph Tracy, 2009. "Second chances: subprime mortgage modification and re-default," Staff Reports, Federal Reserve Bank of New York 417, Federal Reserve Bank of New York.
  12. Dhillon, Upinder S & Shilling, James D & Sirmans, C F, 1987. "Choosing between Fixed and Adjustable Rate Mortgages: A Note," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 19(2), pages 260-67, May.
  13. Brent W. Ambrose & Michael LaCour-Little, 2001. "Prepayment Risk in Adjustable Rate Mortgages Subject to Initial Year Discounts: Some New Evidence," Real Estate Economics, American Real Estate and Urban Economics Association, American Real Estate and Urban Economics Association, vol. 29(2), pages 305-327.
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Cited by:
  1. Andreas Fuster & Paul S. Willen, 2013. "Payment Size, Negative Equity, and Mortgage Default," NBER Working Papers 19345, National Bureau of Economic Research, Inc.
  2. Joanne W. Hsu & David A. Matsa & Brian T. Melzer, 2014. "Positive Externalities of Social Insurance: Unemployment Insurance and Consumer Credit," NBER Working Papers 20353, National Bureau of Economic Research, Inc.

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