Payment shock and mortgage performance
The effect of payment shocks on subprime hybrid ARM mortgage prepayment and delinquency is examined. Using loan level data from private label securities, we modeled the effects of payment shocks on mortgage performance. Our study provided interesting empirical results in three main areas: First, we addressed the effect of payment shocks on subsequent mortgage delinquency. Second, we studied how the effect of payment shocks varies and decays over time. Third, we disentangled the impact of payment shocks based on the reason for the shocks: payment shock due to the expiration of a teaser rate (i.e. "teaser shock") versus the payment shock due to index rate changes at the time of reset (i.e. "market rate shock"). We find that the effect of payment shock on loan performance varies by the delinquency status of the loan at the time of the shock. That is, the payment shock has the most significant effect on "current" loans rather than loans already in delinquency. Also of note, we find that the effect of a payment shock decays only gradually over time. We find that the impact of "teaser shocks" and "market rate shocks" on mortgage performance do not differ substantially, even though teaser shocks may be somewhat more predictable than market rate shocks. This suggests that either subprime ARM borrowers did not fully understand the product and the extent of the shock at the first reset date or that financially strapped borrowers used the product to speculate and were caught by the teaser shock when they were unable to refinance or sell (i.e. "flip") their properties . The study suggests that any modification plan designed to eliminate potential payment shocks or to otherwise lower payments will be most effective for loans that are currently performing rather than loans that are already in delinquency.
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