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.