Effects of Regulation on Prepayment and Default of Subprime Mortgages

1
Effects of Regulation on Prepayment and Default
ofSubprime Mortgages

• Jevgenijs Steinbucks
• Department of Economics - Cambridge University

2
Introduction

• The theoretical model is based on the
  option-pricing structure approach to mortgage
  valuation
• Model seeks two hypotheses
• Eliminating prepayment penalty increases the
  value of the prepayment option
• Eliminating prepayment penalty decreases the
  value of the default option
• Study found prepayments to be higher in regulated
  states, but no definitive conclusion about
  default levels, is the regulation worth it?

3
Empirical Studies

• Danis and Pennington- Cross (2005)
• Subprime with prepayment penalties and limited
  docs resulted in higher defaults.
• Quercia, Stegman, and Davis (2005)
• Controlling for other factors, penalties and
  balloons increased foreclosure risks (more govt)
• Mayer, Piskorski, and Tchistyi (2008)
• Low credit borrowers chose penalties, not
  default, more so than those with no penalties
  (less govt)
• Rose (2008)
• All contract provisions are highly interconnected

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• Subnote from pg. 20
• Danis and Pennington-Cross (2005), and Quercia,
  Stegman, and Davis (2005) find that subprime
  loans with prepayment penalties are more likely
  to experience a foreclosure than loans without
  these characteristics. Mayer, Piskorski, and
  Tchistyi (2008) find that subprime borrowers with
  poor credit history default at a lower rate than
  comparable borrowers with no prepayment
  penalties.

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Theoretical Model

• House and Interest Values
• Both are found using variability and stochastic
  elements.
• Mortgage Value is the difference between
• Future payments
• Value of borrowers prepay option
• in the money when market value is higher than
  refi
• Value of borrowers default option
• mortgage value must be higher than home value
• Prepay and default options are mutually exclusive
  in that when one has value, the other does not.
• The model is built so that at the end of each
  month, if neither option is exercised, it pays
  off additional options for the next month. Given
  this, it must be worked by figuring out the
  solution to the last month, and working backwards.

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Subprime Prepayment Penalties

• Prepayment penalties are higher in subprime
  mortgages, since, even if the yield curve remains
  constant, poor credit borrowers will have more
  incentive to refinance if they improve their
  credit score than prime borrowers, who already
  have rates reflecting a high score.
• Subprime loans are more than three times as
  likely as prime loans to have prepayment penalty
  terms in their mortgage contract, and the
  refinance lock-outs are usually in effect for two
  to five years. (Cutts and van Order 2005).

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Effects of prepayment regulation
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Stochastic Specification

• Econometric approach is based on Kauermann and
  Khomski (2006) competing risk model with
  frailties and penalized splines smoothing.
• Study also presents data of two different models,
  imposing restrictions on the baseline hazard.

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Data

• The data comes from the FSRPs suprime database,
  estimated to contain ¼ of originations
• The dataset is comprehensive, including loan
  rates, points, status, and characteristics.
• Analysis is limited to fixed rate 30 year
  mortgages
• Considers default to be fully foreclosed and REO

originations of higher priced home purchase and
refinance mortgages on owner-occupied homes in
2004 (Avery, Canner, and Cook 2005).
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Call and Put Options

• Using Ho and Pennington-Cross (2006)The call
  option (prepay) is calculated as the PV
  percentage reduction in refi vs. current mortgage
• Using Quigley, Deng, and Van Order (2000) the put
  option (default) calculates the probability of
  the mortgage reaching negative equity.

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Dummy Variables

• Owner Occupy vs. Investor
• Investors had higher default rates
• Broker Origination
• Unclear affect on prepay and default
• Regional Unemployment Uninsured population
• Both factors increased defaults and decreased
  prepayments
• Statewide adoption of predatory lending
  legislation

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Results
Effects of credit regulation on prepayments
Unrestricted - penalized spline baseline hazard
approximation Restricted 1 - quadratic polynomial
baseline hazard approximation Restricted 2 -
baseline hazard not estimated

• In the unrestricted model, cohorts 1 and 2
  initial show lower prepayments, but they increase
  faster with the duration of the loaan
• All three models showed mixed results for
  default correlation, with mostly negative results

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Results (cont.)

• Some inferences about default
• If competing risks in restrictive model 1 are
  negatively correlated, a significant share of bad
  loans in regulated states may have been
  refinanced out of default.
• Unrestricted model shows that early defaults
  (often fraudulent loans) decrease as regulation
  increases.
• All three models seem to indicate that the
  high-cost segment of subprime mortgages are
  riskier.

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Results (cont.)

• The call option in prepayment models were
  positive and significant in most all cases
• The put option showed some positive significance
  on defaults in the unrestricted model and
  restricted model 2.
• The results for other control variables are
  logical and generally consistent with the results
  from previous studies.

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Conclusions

• Data generally agreed with hypotheses that
  increased regulation increases prepayments and
  lowers defaults, although in regards to default,
  the data is mixed an does not strongly support a
  lower default rate with increased regulations.

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QUESTIONS ?