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Mortgage contract choice in subprime mortgage markets

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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.

Suggested Citation

  • Gregory E. Elliehausen & Min Hwang, 2010. "Mortgage contract choice in subprime mortgage markets," Finance and Economics Discussion Series 2010-53, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2010-53
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    Cited by:

    1. J. Mukuddem-Petersen & M. A. Petersen & T. Bosch & B. De Waal, 2011. "Speculative funding and its impact on subprime mortgage product pricing," Applied Financial Economics, Taylor & Francis Journals, vol. 21(19), pages 1397-1408.
    2. David Byrne & Robert Kelly & Conor O'Toole, 2022. "How Does Monetary Policy Pass‐Through Affect Mortgage Default? Evidence from the Irish Mortgage Market," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 54(7), pages 2081-2101, October.
    3. Bulusu, Narayan & Guérin, Pierre, 2019. "What drives interbank loans? Evidence from Canada," Journal of Banking & Finance, Elsevier, vol. 106(C), pages 427-444.
    4. Frederick T. Furlong & Yelena Takhtamanova, 2012. "Did the housing boom affect mortgage choices?," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue nov5.
    5. Steinbuks, Jevgenijs, 2015. "Effects of prepayment regulations on termination of subprime mortgages," Journal of Banking & Finance, Elsevier, vol. 59(C), pages 445-456.

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    Keywords

    Mortgage loans; Subprime mortgage;

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