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The dynamics of subprime adjustable-rate mortgage default: a structural estimation

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Listed:
  • Hanming Fang
  • You Suk Kim
  • Wenli Li

Abstract

We present a dynamic structural model of subprime adjustable-rate mortgage (ARM) borrowers making payment decisions, taking into account possible consequences of different degrees of delinquency from their lenders. We empirically implement the model using unique data sets that contain information on borrowers' mortgage payment history, their broad balance sheets, and lender responses. Our investigation of the factors that drive borrowers' decisions reveals that subprime ARMs are not all alike. For loans originated in 2004 and 2005, the interest rate resets associated with ARMs as well as the housing and labor market conditions were not as important in borrowers' delinquency decisions as in their decisions to pay o_ their loans. For loans originated in 2006, interest rate resets, housing price declines, and worsening labor market conditions all contributed importantly to their high delinquency rates. Counterfactual policy simulations reveal that even if the London Interbank Offered Rate (LIBOR) could be lowered to zero by aggressive traditional monetary policies, it would have a limited effect on reducing the delinquency rates. We find that automatic modification mortgages with cushions, under which the monthly payment or principal balance reductions are triggered only when housing price declines exceed a certain percentage, may result in a Pareto improvement, in that borrowers and lenders are both made better o_ than under the baseline, with lower delinquency and foreclosure rates. Our counterfactual analysis also suggests that limited commitment power on the part of the lenders regarding loan modification policies may be an important reason for the relatively low rate of modifications observed during the housing crisis.

Suggested Citation

  • Hanming Fang & You Suk Kim & Wenli Li, 2016. "The dynamics of subprime adjustable-rate mortgage default: a structural estimation," Working Papers 16-2, Federal Reserve Bank of Philadelphia.
  • Handle: RePEc:fip:fedpwp:16-2
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    Cited by:

    1. Reed, Robert R. & LaRue, Amanda & Ume, Ejindu S., 2018. "Mortgage recourse provisions and housing prices," Regional Science and Urban Economics, Elsevier, vol. 73(C), pages 99-111.
    2. Jason R. Blevins & Wei Shi & Donald R. Haurin & Stephanie Moulton, 2020. "A Dynamic Discrete Choice Model Of Reverse Mortgage Borrower Behavior," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 61(4), pages 1437-1477, November.
    3. Xudong An & Lawrence R. Cordell, 2017. "Regime Shift And The Post-Crisis World Of Mortgage Loss Severities," Working Papers 17-8, Federal Reserve Bank of Philadelphia.

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    More about this item

    Keywords

    Adjustable-rate mortgage; Default; Loan modification; Automatic modification mortgages with cushions;
    All these keywords.

    JEL classification:

    • D12 - Microeconomics - - Household Behavior - - - Consumer Economics: Empirical Analysis
    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • G2 - Financial Economics - - Financial Institutions and Services
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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