Mortgage Contract Choice in Subprime Mortgage Markets

56 Pages Posted: 29 Jul 2011

See all articles by Gregory Elliehausen

Gregory Elliehausen

George Washington University - Financial Services Research Program

Min Hwang

George Washington University - Department of Finance

Date Written: May 20, 2010

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: Mortgages, household financial decisions

Suggested Citation

Elliehausen, Gregory and Hwang, Min, Mortgage Contract Choice in Subprime Mortgage Markets (May 20, 2010). FEDS Working Paper No. 2010-53. Available at SSRN: https://ssrn.com/abstract=1898345 or http://dx.doi.org/10.2139/ssrn.1898345

Gregory Elliehausen (Contact Author)

George Washington University - Financial Services Research Program ( email )

Duques Hall, Suite 551
2201 G Street, NW
Washington, DC 20052
United States
202-994-0892 (Phone)
202-994-0907 (Fax)

Min Hwang

George Washington University - Department of Finance ( email )

2023 G Street
Washington, DC 20052
United States

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