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Published by: caitlynharvey on Jan 14, 2013
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No. 12-
Payment Size, Negative Equity, and MortgageDefault
Andreas Fuster and Paul S. WillenAbstract:
Surprisingly little is known about the importance of mortgage payment size for default, asefforts to measure the treatment effect of rate increases or loan modifications are confounded by borrower selection. We study a sample of hybrid adjustable-rate mortgages that haveexperienced large rate reductions over the past years and are largely immune to theseselection concerns. We show that interest rate changes dramatically affect repayment behavior. Our estimates imply that cutting a borrower’s payment in half reduces his hazardof becoming delinquent by about two-thirds, an effect that is approximately equivalent tolowering the borrower’s combined loan-to-value ratio from 145 to 95 (holding the paymentfixed). These findings shed light on the driving forces behind default behavior and haveimportant implications for public policy.
JEL Classifications:
G21, E43
Andreas Fuster is a financial economist in the capital markets section of the research and statistics group of theFederal Reserve Bank of New York. Paul S. Willen is a senior economist and policy advisor in the researchdepartment of the Federal Reserve Bank of Boston and a faculty research fellow at the National Bureau ofEconomic Research. Their email addresses are
andreas.fuster@ny.frb.organdpaul.willen@bostonfed.org ,
respectively.We are grateful to Ronel Elul, Andy Haughwout, Joe Tracy, and participants at the Workshop on ConsumerCredit and Payments at the Federal Reserve Bank of Philadelphia for helpful comments and discussions.The views expressed in this paper are those of the authors and not necessarily those of the Federal Reserve Bankof Boston or New York or the Federal Reserve System.This paper, which may be revised, is available on the web site of the Federal Reserve Bank of Boston athttp://www.bostonfed.org/economic/ppdp/index.htm.
version of: November 10, 2012.
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)
the 7/1+ loans was lower than that of the 5/1s, but after the reset the default hazard comesin dramatically lower for the 5/1s.
While this figure is strongly suggestive, it obviously does not provide conclusive evidenceon the strength of the effects of payment reductions. In the remainder of this paper, we usestatistical techniques to show that the payment reductions indeed caused the changes in thedefault hazards, and we quantify the size of the effect. In particular, we focus on comparingthe effects of an interest rate reduction with that of reducing a borrower’s negative equityposition (while holding the payment size constant).Our estimates indicate that a 2-percentage point reduction in the interest rate chargedto a borrower has effects on the default hazard approximately equivalent, for instance, toreducing the borrower’s combined loan-to-value ratio (CLTV) from 135 to 100.
A reductionof 4 percentage points or more, which indeed applied to about 20 percent of 5/1s in oursample, has approximately the same predicted effect on the delinquency hazard as a reductionin the CLTV from 155 to 80. As an alternative way to quantify the effect, our estimatesimply that an interest rate decrease of 3 percentage points for a group of “typical” 5/1s atage 61 months (close to the mean reduction such loans actually experienced) with a CLTVbetween 130 and 140 reduces the number of delinquencies for these loans over the year afterthe reset by about 10 percentage points, or more than half .
This illustrates the broaderand important finding that our estimated effects are similar if we look at only a subset of borrowers in our sample who are severely underwater. As we show, this is consistent withbasic finance theory and goes against the intuition held by some commentators that once aborrower’s mortgage is sufficiently far underwater, it is always optimal for him to default.An interesting question is at what point in time the effects of a predictable interest ratedecrease actually occur. The default decision of a borrower who understands the terms of his mortgage, tracks the underlying index (for example, the one-year LIBOR), and is notliquidity constrained should not be affected by the actual occurrence of the reset. Instead,such a borrower would, in each period, consider the expected rate path over all futureperiods and decide accordingly whether default is optimal today, given his equity positionand his expectations of future house prices. We find little evidence for effects of interest ratereductions on delinquency occurring much ahead of the actual reset, suggesting that either
We follow industry convention in referring to loans that reset after
years as “
/1” with the 1 referringto the annual frequency of subsequent adjustments, generating a slight abuse of terminology as a majorityof the ARMs in our sample actually adjust every 6 months.
A major advantage of the dataset we use over most of the previous literature is that for a large fractionof loans, we have updated information on the current CLTV, including all liens on a property.
Such counterfactuals account for the fact that payment reductions also reduce the hazard of prepayment,as shown in Panel C of Figure1.For underwater loans, the prepayment hazard is very low, so reductions in the default hazard translate almost directly into reductions in the number of defaults.

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