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Mortgage default and low downpayment loans: The costs of public subsidy

  • Deng, Yongheng
  • Quigley, John M.
  • Van Order, Robert
  • Mac, Freddie

This paper presents a unified model of the default and prepayment behavior of homeowners in a proportional hazard framework. The model uses the option-based approach to analyze default and prepayment and considers these two interdependent hazards as competing risks. The results indicate the sensitivity of default to the initial loan-to-value ratio of the loan and the course of housing equity. The latter is a measure of the extent to which the default option is in the money. The results also indicate the importance of trigger events, namely unemployment and divorce, in affecting prepayment and default behavior. The empirical results are used to analyze the costs of a current policy proposal -- stimulating homeownership by offering low downpayment loans. We simulate default probabilities and costs on zero-downpayment loans and compare them to conventional loans with conventional underwriting standards. The results indicate that if zero-downpayment loans were priced as if they were mortgages with ten percent downpayments, then the additional program costs would be two to four percent of funds made available -- when housing prices increase steadily. If housing prices remained constant, the costs of the program would be much larger indeed. Our estimates suggest that additional program costs could be between $74,000 and $87,000 per million dollars of lending. If the expected losses from such a program were not priced at all, the losses from default alone could exceed ten percent of the funds made available for loans.

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Article provided by Elsevier in its journal Regional Science and Urban Economics.

Volume (Year): 26 (1996)
Issue (Month): 3-4 (June)
Pages: 263-285

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Handle: RePEc:eee:regeco:v:26:y:1996:i:3-4:p:263-285
Contact details of provider: Web page: http://www.elsevier.com/locate/regec

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  1. Karl E. Case & Robert J. Shiller, 1987. "Prices of Single Family Homes Since 1970: New Indexes for Four Cities," Cowles Foundation Discussion Papers 851, Cowles Foundation for Research in Economics, Yale University.
  2. Stephen A. Buser & Patric H. Hendershott & Anthony B. Sanders, 1984. "Pricing Rate Caps on Default-Free Adjustable-Rate Mortgages," NBER Working Papers 1525, National Bureau of Economic Research, Inc.
  3. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  4. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
  5. Jerry Green & John B. Shoven, 1983. "The Effects of Interest Rates on Mortgage Prepayments," NBER Working Papers 1246, National Bureau of Economic Research, Inc.
  6. John M. Quigley & Robert Order, 1990. "Efficiency in the Mortgage Market: The Borrower's Perspective," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 18(3), pages 237-252.
  7. Schwartz, Eduardo S & Torous, Walter N, 1989. " Prepayment and the Valuation of Mortgage-Backed Securities," Journal of Finance, American Finance Association, vol. 44(2), pages 375-92, June.
  8. Quigley, John M., 2006. "Urban Economics," Berkeley Program on Housing and Urban Policy, Working Paper Series qt0jr0p2tk, Berkeley Program on Housing and Urban Policy.
  9. Patric H. Hendershott & Robert Van Order, 1987. "Pricing Mortgages: An Interpretation of the Models and Results," NBER Working Papers 2290, National Bureau of Economic Research, Inc.
  10. Cunningham, Donald F & Capone, Charles A, Jr, 1990. " The Relative Termination Experience of Adjustable to Fixed-Rate Mortgages," Journal of Finance, American Finance Association, vol. 45(5), pages 1687-1703, December.
  11. Chester Foster & Robert Order, 1985. "FHA Terminations: A Prelude to Rational Mortgage Pricing," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 13(3), pages 273-291.
  12. Dunn, Kenneth B & McConnell, John J, 1981. "Valuation of GNMA Mortgage-Backed Securities," Journal of Finance, American Finance Association, vol. 36(3), pages 599-616, June.
  13. Kau, James B, et al, 1992. "A Generalized Valuation Model for Fixed-Rate Residential Mortgages," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 24(3), pages 279-99, August.
  14. Kau, James B, et al, 1995. "The Valuation at Origination of Fixed-Rate Mortgages with Default and Prepayment," The Journal of Real Estate Finance and Economics, Springer, vol. 11(1), pages 5-36, July.
  15. Michael J. Brennan & Eduardo S. Schwartz, 1985. "Determinants of GNMA Mortgage Prices," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 13(3), pages 209-228.
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