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

53 Pages Posted: 4 Feb 2016  

Hanming Fang

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

You Jin Kim

Temple University - Department of Human Resource Management

Wenli Li

Federal Reserve Bank of Philadelphia

Date Written: 2016-01-11

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 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 off 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.

Keywords: Adjustable-rate mortgage, Default, Loan modification, Automatic modification mortgages with cushions

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

Suggested Citation

Fang, Hanming and Kim, You Jin and Li, Wenli, The Dynamics of Subprime Adjustable-Rate Mortgage Default: A Structural Estimation (2016-01-11). FRB of Philadelphia Working Paper No. 16-2. Available at SSRN: https://ssrn.com/abstract=2727646

Hanming Fang (Contact Author)

University of Pennsylvania - Department of Economics ( email )

160 McNeil Building
3718 Locust Walk
Philadelphia, PA 19104
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

You Jin Kim

Temple University - Department of Human Resource Management ( email )

Philadelphia, PA 19122
United States

Wenli Li

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

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