A New Hedonic Method for Measuring Mortgage Default Risk and Prepayment Rate

15 Pages Posted: 31 Aug 2018 Last revised: 19 Oct 2018

See all articles by Kai Lin

Kai Lin

Coolabah Capital

Ainslie Yuen

Coolabah Capital

Christopher Joye

Coolabah Capital

Date Written: October 15, 2018

Abstract

Measuring and monitoring the true level of mortgage delinquencies across an economy is essential for asset pricing and financial system stability. Yet public measures of mortgage default risk almost always use simple averages across pools of individual assets, including balance-sheet loans or indices tracking default risk across portfolios of residential mortgage-backed securities (RMBS). These approaches are, like median house price indices, afflicted by compositional biases that can lead to spurious inferences regarding the direction of default rates. Sources of bias include artificial changes in default rates attributable to: increases in the volume of new loans being written or (securitised RMBS added to indices); changes in the proportion of transactions with higher loan-to-value ratios (LVRs); the introduction of less seasoned RMBS transactions with a lower weighted-average loan age; and/or shifts in borrower characteristics that have higher probabilities of default (e.g. tilts towards investment borrowers). To address this problem, we have developed the first known hedonic regression-based indices of empirical mortgage default risk that explicitly control for compositional biases through the models’ characteristic-based independent variables. Whereas simple average measures of default rates across securitised loan portfolios have declined in recent years, which suggests that the risk of loss has been falling, our hedonic mortgage default index implies exactly the opposite: that is, compositionally-adjusted default rates have, in fact, been increasing sharply in recent times. In addition to delinquency rates, we apply similar hedonic regression techniques to create a compositionally-adjusted index for RMBS prepayment rates, which shows a sharp decline in prepayments from 2017 to late 2018.

Keywords: Mortgages, Defaults, Hedonic, Securitisation, Mortgage Risk, Mortgage Delinquencies, Default Risk, Hedonic Regression, RMBS

Suggested Citation

Lin, Kai and Yuen, Ainslie and Joye, Christopher, A New Hedonic Method for Measuring Mortgage Default Risk and Prepayment Rate (October 15, 2018). Available at SSRN: https://ssrn.com/abstract=3237169 or http://dx.doi.org/10.2139/ssrn.3237169

Kai Lin

Coolabah Capital ( email )

Suite 2502 of Level 25, Westfield Tower 2,
101 Grafton Street, Bondi Junction
Sydney, New South Wales 2022
Australia

HOME PAGE: http://coolabahcapital.com/

Ainslie Yuen (Contact Author)

Coolabah Capital ( email )

Suite 2502 of Level 25, Westfield Tower 2,
101 Grafton Street, Bondi Junction
Sydney, New South Wales 2022
Australia

HOME PAGE: http://coolabahcapital.com/

Christopher Joye

Coolabah Capital ( email )

Suite 2502 of Level 25, Westfield Tower 2,
101 Grafton Street, Bondi Junction
Sydney, New South Wales 2022
Australia

HOME PAGE: http://coolabahcapital.com/

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