The Dynamics of Adjustable-Rate Subprime Mortgage Default: A Structural Estimation

54 Pages Posted: 12 Dec 2015

See all articles by Hanming Fang

Hanming Fang

University of Pennsylvania - Department of Economics; National Bureau of Economic Research (NBER)

You Suk Kim

Board of Governors of the Federal Reserve System

Wenli Li

Federal Reserve Bank of Philadelphia

Multiple version iconThere are 3 versions of this paper

Date Written: December 9, 2015

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 off 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 Labor rate 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 mortgage designs under which the monthly payment or the principal balance of the loans are automatically reduced when housing prices decline can be effective in reducing both delinquency and foreclosure. Importantly, we find that automatic modification mortgages with a cushion, 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 off than under the baseline, with a lower delinquency and foreclosure rates. Our counterfactual analysis also suggests that limited commitment power on the part of the lenders to loan modification policies may be an important reason for the relatively small rate of modifications observed during the housing crisis.

Keywords: Adjustable-Rate Mortgage, Default, Loan Modification, Automatic Modification with a Cushion

JEL Classification: D12, D14; G2, G21, G33

Suggested Citation

Fang, Hanming and Kim, You Suk and Li, Wenli, The Dynamics of Adjustable-Rate Subprime Mortgage Default: A Structural Estimation (December 9, 2015). PIER Working Paper No. 041. Available at SSRN: https://ssrn.com/abstract=2702430 or http://dx.doi.org/10.2139/ssrn.2702430

Hanming Fang (Contact Author)

University of Pennsylvania - Department of Economics ( email )

Ronald O. Perelman Center for Political Science
133 South 36th Street
Philadelphia, PA 19104-6297
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

You Suk Kim

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Wenli Li

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

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