The dynamics of subprime adjustable-rate mortgage default: a structural estimation
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.
File(s): File format is application/pdf https://www.philadelphiafed.org/-/media/frbp/assets/working-papers/2016/wp16-02.pdf
Provider: Federal Reserve Bank of Philadelphia
Part of Series: Working Papers
Publication Date: 2016-01-11
Pages: 53 pages