Mortgage contract choice in subprime mortgage markets

Gregory E. Elliehausen and Min Hwang

No 2010-53, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

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: Mortgage loans; Subprime mortgage (search for similar items in EconPapers)
Date: 2010
New Economics Papers: this item is included in nep-ban and nep-ure
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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