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Payment Size, Negative Equity, and Mortgage Default

Payment Size, Negative Equity, and Mortgage Default



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Published by: caitlynharvey on Nov 21, 2012
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This paper presents preliminary
ndings and is being distributed to economistsand other interested readers solely to stimulate discussion and elicit comments.The views expressed in this paper are those of the authors and are not necessarilyre
ective of views at the Federal Reserve Bank of New York or the FederalReserve System. Any errors or omissions are the responsibility of the authors.
Federal Reserve Bank of New York Staff Reports
Staff Report No. 582November 2012
Andreas FusterPaul S. Willen
Payment Size, Negative Equity,and Mortgage Default
S ff  
Fuster: Federal Reserve Bank of New York (e-mail: andreas.fuster@ny.frb.org). Willen:Federal Reserve Bank of Boston (e-mail: paul.willen@bos.frb.org). For helpful comments anddiscussions, the authors are grateful to Ronel Elul, Andy Haughwout, Joe Tracy, and participantsat the Workshop on Consumer Credit and Payments at the Federal Reserve Bank of Philadelphia.The views expressed in this paper are those of the authors and do not necessarily re
ect theposition of the Federal Reserve Bank of Boston, the Federal Reserve Bank of New York, or theFederal Reserve System.
Surprisingly little is known about the importance of mortgage payment size for default,as efforts to measure the treatment effect of rate increases or loan modi
cationsare confounded by borrower selection. We study a sample of hybrid adjustable-ratemortgages that have experienced large rate reductions over the past years and are largelyimmune to these selection concerns. We show that interest rate changes dramaticallyaffect repayment behavior. Our estimates imply that cutting a borrower’s payment inhalf reduces his hazard of becoming delinquent by about two-thirds, an effect that isapproximately equivalent to lowering the borrower’s combined loan-to-value ratio from145 to 95 (holding the payment
xed). These
ndings shed light on the driving forcesbehind default behavior and have important implications for public policy.Key words: mortgage
nance, delinquency, ARMs, Alt-A, TrueLTV
Payment Size, Negative Equity, and Mortgage Default
Andreas Fuster and Paul S. Willen
Federal Reserve Bank of New York Staff Reports,
no. 582November 2012JEL classi
cation: G21, E43
1 Introduction
Measuring the relative importance of payment size and negative equity is a central question inthe analysis of the mortgage default decision. Recent policy debates have pitted proponentsof principal reductions who argue that only the latter matters against opponents who arguethat monthly payment reductions are sufficient to prevent most defaults.
Early in the crisis,the dominant view was that foreclosures were entirely, or almost entirely, the result of risingmonthly payments (for example,Bair 2007andEakes 2007). However, others such asFoote, Gerardi, and Willen(2012) have argued that payment increases of adjustable-rate loans were not a major driving factor behind the foreclosure crisis, based on the fact that the numberof defaults does not seem to react much even to large payment increases.In this paper, we contribute to this debate by exploiting the resets of Alt-A hybridadjustable-rate mortgages (ARMs) over the period 2008–2011. Hybrid ARMs have fixedpayments for 3, 5, 7, or 10 years and then adjust annually or semiannually until the mortgagematures, meaning that the borrower’s required monthly payment can adjust substantiallyat a particular moment in the life of the mortgage. What makes our sample unique isthat, because of the changed macroeconomic environment, required payments on most of these loans
at the reset, often dramatically (see Panel A of Figure1). This gives us anadvantage over previous work, because, as we explain in Section2, the prepayment optionmakes it impossible to use payment
to measure the effects of payment changes onmortgage defaults.We compare the performance of mortgages before and after payment reductions to theperformance of otherwise similar mortgages that did not receive a contemporaneous paymentreduction, either because the loan was originated at a different time or because it had adifferent fixed payment period. We find that payment reductions have very large effects.Panel B of Figure1plots the hazard of becoming 60-days delinquent for three types of loans as a function of the number of months since the origination of the loan. It shows thehazard for ARMs that reset after 5 years (“5/1”) dropping from 1.7 percent in month 58(three months prior to reset) to 0.5 percent by month 64 (after the reset). Payments forthese borrowers had fallen on average by more than 3 percentage points, or 50 percent. TheARMs that reset after 7 or 10 years (“7/1+”) and thus had not yet reset in our observationperiod provide our control group. Until month 60, shortly prior to the reset, the hazard of 
A recent
Wall Street Journa
article illustrates the debate: “Economists are split. ‘There’s no questionthat in many cases, [principal forgiveness] is the only way to assure people will stay in the house,’ saysKenneth Rosen of the University of California, Berkeley. Others say what really matters to borrowers is anaffordable monthly payment. ‘If people have a huge debt burden but the mortgage is not the problem, whyare we reducing the mortgage?’ asks Thomas Lawler, an independent housing economist in Leesburg, Va.”(“How Forgiveness Fits in Housing-Fix Toolkit,” p. A2, July 30, 2012)

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