Working Paper

Mortgage contract choice in subprime mortgage markets

Abstract: The boom in the subprime mortgage market yielded many loans with high LTV ratios. From a large proprietary database on subprime mortgages, we find that choice of mortgage rate type is not linear in loan sizes. A fixed rate mortgage contract is a popular choice when loan size, measured by LTV ratio, is small. As LTV ratio increases, borrowers become more likely to choose adjustable rate mortgage contracts. However, when LTV reaches a certain level, borrowers start to switch back to fixed rate contracts. For these high LTV loans, fixed rate mortgages dominate borrowers' choices. We present a very simple model that explains this \"nonlinear\" pattern in mortgage instrument choice. The model shows that the choice of mortgage rate type depends on two opposing effects: a \"term structure\" effect and an \"interest rate volatility\" effect. When the loan size is small, the term structure effect dominates: rising LTV ratios making ARM loans less costly, and more attractive. However, when the loan size is large enough, the interest volatility effect dominates: rising LTV ratios making FRM loans less costly and preferable. We present strong empirical evidence in support of the model predictions.

Keywords: Mortgage loans; Subprime mortgage;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2010

Number: 2010-53