The valuation of alternative mortgage instruments and household behaviour
The analysis so far has focused on the case of a conventional for the US fixed rate mortgage. Given the importance of the adjustable rate mortgage in the US then the question naturally arises as to the implications of more frequent interest rate adjustments for the valuation of an ARM mortgage contract. This is also true of the variable rate mortgage VRM in the UK. In addition, the fixed rate mortgage in the UK has some distinctive features Pereira et al. 2002 for example, the payment of...
The theoretical basis of mortgage demand
Existing theoretical models of mortgage demand suggest a complex set of relationships, not least arising from the joint consumption investment aspects of housing see Ioannides 1989 Brueckner 1997 . In fact, many of the mathematical models developed in this area do not have closed form solutions e.g. Alm amp Follain 1987 . However, the formal models do offer important insights into the basis of mortgage demand, links with the demand for housing services, and other related decisions. Certainly...
Information asymmetry and mortgage contract heterogeneity
The theoretical discussion of rationing in Chapter 5, and its empirical treatment in Chapter 6, focused upon the importance of asymmetric information in the mortgage market. There is now a rich vein of largely theoretical literature arguing that mortgage contracts of different design exist as screening devices that signal important, and otherwise unobservable, characteristics of borrowers to lenders Dunn amp Spatt 1988 Brueckner 1992, Chari amp Jagannathan 1989 Brueckner 1994b, c, 2000 LeRoy...
Default and prepayment behaviour as competing risks
It has been increasingly recognised that default and prepayment behaviour are best viewed as competing risks, where exercising one option precludes the exercise of the other Deng et al. 1996 Pavlov 2001, Deng et al. 2000 Clapp et al. 2001 Ambrose amp LaCour Little 2001 Colhoun amp Deng 2002 . This work has been based on either the competing risk proportional hazard models, or the multinomial logit model. The research generally finds that the option theoretic approach is important and can...
A classification of credit rationing in the mortgage market
This section explores the various conditions under which credit rationing can occur. Rationing arises when the effective demand for funds exceeds the supply, with the observed amount of mortgage debt being equivalent to the short side of the market. Some writers have defined mortgage market rationing in terms of the use of non-price features of mortgage contracts, for example the loan-to-value ratio, to decide the allocation of credit when mortgage markets are in disequilibrium Kent 1987 . For...
Equilibrium rationing separating equilibrium and liquidity constraints
This section examines the evidence for equilibrium credit rationing Sti-glitz amp Weiss 1981 Williamson 1986, 1987 . Given that empirical research in this area is sparse, then both UK and US work are discussed together. The US is particularly interesting in that default risk is fully insured for the Federal Housing Association, but not for the alternative conventional lenders. This has led to a number of interesting studies. For example, Duca amp Rosenthal 1991 use time series data to explore...
An overview of the option theoretic approach to mortgage valuation
The valuation of a mortgage contract can be seen as the value of three different forms of security. The actual contract terms, and the discounted cash flows to the lender using the current market rate of interest can be represented as a non-callable bond. However, the borrower has both the option to prepay or to default on the mortgage. The option to default is a put option involving the possibility of selling the property back to the lender to repay the outstanding debt. The option to prepay...
The prepayment behaviour of the wealth maximising borrower
The option theoretic approach to mortgage valuation offers an explanation of prepayment behaviour. This behaviour results from breaching a boundary condition for the value of a risky mortgage involving those values of H and r which induce prepayment. This boundary is known as a free boundary because the borrower can prepay the debt at any time during the life of the current mortgage contract, and will do so depending upon the combination of r and H. This is the main reason why we work backwards...
Disequilibrium rationing
The most clear cut example of disequilibrium rationing is the UK mortgage market in the 1970s and early 1980s. Up to 1983 UK mortgage finance was controlled by a cartel of building societies mutual organisations . The existence of disequilibrium rationing in the United States is more controversial Meltzer 1974 Hendershott 1981 Jaffee amp Rosen 1979 , though Kent 1987 cites 1966, 1969-70 and 1974-75 as periods when disequilibrium credit rationing might have been evident in the US economy. In the...
The choice of mortgage instrument in the United Kingdom
Many of the questions explored in the US research are relevant to the UK mortgage market. In the UK the innovation was the fixed rate mortgage fixed rate 1 which became popular in the early 1990s see Figure 8.2 . Mirroring US research we can ask several pertinent questions. What is the impact of the FRM-VRM interest rate differential on the choice of a fixed rate mortgage Do wealth and personal characteristics influence mortgage choice Are the choice of mortgage instrument and mortgage housing...
Notes Duj
1 For example, it has been argued that the ARM increases aggregate housing demand and reduces the interest rate elasticity of housing demand Goodman 1992, p. 1 . 2 If the premium is viewed simply as a relative cost then interest rate expectations are typically modelled using a variable reflecting the term structure of interest rates, with variations in expectations assumed to be captured by the error term. 3 For example, the presence of children in a household is used as an indicator of risk...
Interest rate expectations and mortgage contract heterogeneity
Several of the models discussed above have focused upon interest rate expectations. For example, the slope of the yield curve was an important determinant of ARM choice Brueckner 1993 . Also the models were based upon draws from probability density functions of interest rates, which if they are to explain borrowers' choices imply an interest rate expectations mechanism, or at least knowledge of the variance of the interest rate distribution. In this section we consider the question of interest...
The links between prepayment and default behaviour
Research using numerical simulation focuses upon the effects of changes in the state variables, and their volatilities, upon the value of the risky mortgage debt Kau amp Keenan 1995 Pereira et al. 2002 . This involves analysis of the different components of the risky mortgage, that is the embedded options and the value of the cash flows on the debt. Default and prepayment are seen as a joint probability of mortgage termination. A related consideration, and the main focus of empirical work, is...
Mortgage termination behaviour and alternative mortgage instruments
Previous chapters noted that economic behaviour might differ according to the type of mortgage instrument. This involves aspects of both signalling and selectivity. For example, it was suggested that households choosing an ARM might be more mobile and more inclined to default. Prepayment behaviour was generally considered for samples of fixed rate mortgage holders. However, the presence of interest rate floors and caps and the use of 'teaser rates' has meant that adjustable rate mortgages also...
Some general issues encountered in estimating mortgage demand equations
Recent North American and UK research into the demand for mortgage finance has raised and accommodated several important estimation issues and measurement problems. These can be listed as follows The censoring of data for example zero mortgage holdings by some owner occupiers . The truncation of the distribution of observed mortgage balances under credit rationing that is some borrowers obtain less than their desired amounts of debt . The simultaneous determination of mortgage and housing...
Mortgage instruments for dealing with the tilt
There are a number of mortgage instruments that can assist in overcoming capital market imperfections and replace mortgage contract designs that suffer from the tilt. Mortgage contracts vary in the manner and extent to which risk is shared between the borrower and the lender. For example, the variable rate mortgage places the adverse effects of unanticipated inflation with the borrower. The borrower takes the full burden of the tilting of mortgage payments. In contrast the fixed rate mortgage...