Perspectives on the maturity of mortgage debt

The maturity of mortgage debt, as a contractual feature and a household choice, has played a variety of roles in the mortgage economics literature. For example, the analysis of mortgage credit rationing by Kent (1980) focuses upon maturity as an element of the mortgage contract that can be varied to clear the mortgage market when it is in temporary disequilibrium. Moreover, the maturity of debt can be used as an indicator of mortgage credit rationing. This view should be qualified to the extent...

Summary and conclusions

The chapter began with a classification of credit rationing into disequilibrium, equilibrium and dynamic rationing. Though the distinctions were somewhat arbitrary, and often have asymmetric information has a common causal factor, they do provide a useful way of viewing credit rationing in mortgage markets. The categories will also guide our review of empirical material. Disequilibrium rationing focuses upon the possible impact of financial deregulation and household behaviour, pre- and...

Empirical research in the United Kingdom

The background to United Kingdom research The theoretical discussion in Chapter 2 noted the importance of the difference between the net of tax mortgage interest rate, and the rate of return on equity in a property. Muellbeur & Murphy (1997) argued that the rate of return on a building society share account seems the most appropriate forgone rate of return for the UK. Research in the US presumed that the net of tax mortgage rate was lower than the savings rate. In the UK net of tax mortgage...

Modelling mortgage demand under conditions of uncertainty

Modelling mortgage demand assuming a world where the value of key economic variables is known with certainty has provided a concise modelling framework with clear predictions in some cases and sometimes involving corner solutions. A key variable in the maximisation of the consumer's utility function was the level of second period wealth W. Theoretical research has also focused upon the stochastic nature of W, an approach that invites the application of modern portfolio theory to mortgage...

The study of mortgage termination behaviour

There are two perspectives on mortgage termination research. One is to consider the 'ruthless' and endogenously determined exercise of the embedded call and put options (see, for example, Green & Shoven 1986 Schwartz & Torous 1989a, 1989b, 1992, 1993). A second perspective has recognised that exogenous factors may influence termination decisions. In the case of prepayment this is known as estimating an empirical prepayment function, while for default concern has been with 'trigger...

Notes

1 See for example, Elton, J.E. & M.J. Gruber (1991) Modern Portfolio Theory and Investment Analysis, John Wiley & Sons Inc., New York, Chichester, 4th edition, chapters 2 and 3, pp. 15-64. 2 The first order conditions, not reported here, are derived using the Kuhn Tucker theorem. 3 See Brueckner (1994a, p. 255). 4 In theory the appropriate opportunity cost of equity in a property is an asset with the same risk return characteristics. In the model under certainty we can assume such...

Introduction

A study of credit rationing is important because such rationing can impact upon household behaviour and welfare. Credit rationing can effect tenure choice, levels of housing consumption and life cycle planning. Similarly financial deregulation which reduces credit rationing can exacerbate the tendency for boom and bust cycles in the housing market (Dale-Johnson 1995 Ortalo-Magne & Rady 1998, 1999, 2002). In some economies the extent of credit rationing reflects, and is effected by, the...

Mortgage market adjustment and dynamic credit rationing

The mortgage markets can be in temporary disequilibrium when interest rate adjustments are sluggish. The slow adjustment of interest rates on debt can also reflect the impact of credit rationing, though not necessarily (see Berger & Udell 1992). For example, lenders may enter an implicit risk sharing agreement with borrowers. Slow upward adjustments of the cost of debt can also create temporary excess demand. How quickly and in what manner mortgage interest rates adjust to exogenous shocks...

Why study household behaviour The rationale of this book

Radical changes in housing finance systems give the study of consumer behaviour in mortgage markets extra imperative. Financial deregulation during the 1980s paved the way for major structural changes in mortgage markets. In both the US and the UK the right to sell mortgage debt was extended to a wider range of financial institutions. Recent history has seen the rise of specialist mortgage banks, securitisation, the cross-border sale of mortgages, the growing importance of information...

Mortgage demand other mortgage choices and the nature of the economic environment

This section of the book examines the links between mortgage demand and the other major mortgage choices. These choices include mortgage prepayment, default on mortgage debt, rates of amortisation, and choices between different mortgage instruments (contract design). The choices will in turn be influenced by the nature of the economic environment, for example the existence and extent of credit rationing, or the ability to hedge against risk and uncertainty. Although seemingly disparate topics a...

The role of the flexible amortisation of mortgage debt

The previous discussion noted how liquidity constrained borrowers will be concerned with the tilting of real mortgage payments towards the early years of the mortgage. Other households may not be so constrained by considerations of affordability, and be more concerned with cost minimisation over the life of the debt (Breslaw et al. 1996). Both of these choice dimensions involve the rate at which debt can be, or actually is, amortised, an important aspect of mortgage design. This still involves...

The tilt and cash constraints

The discussion of mortgage demand presented in Chapter 2 and Chapter 3 briefly noted the importance of the so called tilt, that is the tilting of the real value of mortgage payments towards the early years of the debt. The presence of the tilt meant that borrowers might experience cash flow problems, and a case was made for using the nominal, rather than the real mortgage interest rate when estimating mortgage demand equations. The tilt is likely to be particularly problematic at times of high...

Contents

1 An Introduction to Mortgage Market Economics 1 The different mortgage markets 3 The secondary mortgage market 14 Why study household behaviour The rationale of this book 18 2 The Demand for Mortgage Finance Theory 28 The theoretical basis of mortgage demand 29 Modelling mortgage demand under conditions of certainty 30 Modelling mortgage demand under conditions of Down payment constraints and mortgage demand 37 Mortgage demand, other mortgage choices and the nature 3 The Demand for Mortgage...

Asymmetric information and equilibrium credit market rationing

Posey And Yavas 2001 Equilibria

The discussion in this section of the book examines how equilibrium credit rationing can arise in situations of asymmetric information. A good example of information asymmetry between the borrower and the lender is the borrower's propensity to default on mortgage payments. In particular the likelihood of default may relate to the psychic costs of default, which are essentially unobservable Brueckner 2000 . Under certain conditions heterogeneous mortgage contracts and information asymmetry may...

Default specific studies

Though the emphasis so far has been on econometric estimation involving the competing risks of prepayment and default, a number of studies focusing upon one or the other of these behaviours have added important insights. Such research also provides a benchmark against which to judge the knowledge gained, and improvements in estimation following from adopting competing risk models. This and the following section also serve to remind us of the specific predictions of the pure option theory of...

United Kingdom disequilibrium mortgage credit rationing research

Chapter 5 cited the UK mortgage market in the 1970s, and early 1980s, as a prime example of disequilibrium rationing. The existence of a mortgage cartel until 1983, and periods of negative real interest rates, led to mortgage queues and the use of non-price rationing mechanisms. These are the results we would expect if non-price terms of mortgage contracts were not being adjusted to clear the market Drake amp Holmes 1997 . Thus the UK provides an ideal setting for the study of disequilibrium...

Measurement issues in specifying mortgage termination models

One difficulty in testing option theoretic models is that the theoretical variables cannot always be measured directly. For example, the net value of the option to default or prepay which can inhibit mortgage termination, even when the option is 'in the money'. In the case of default, the value of the put option will depend upon the stochastic behaviour of particular house prices. Measuring the extent to which an option is 'in the money' its intrinsic value can also be problematic. Given that...

Approaches to the econometric modelling of mortgage termination behaviour

In this section we examine the approaches adopted to the econometric modelling of mortgage termination behaviour. This includes a discussion of the sampling and data issues involved in any estimation. As with most other research endeavours data is not always complete and theoretical variables are represented by proxy measures which require careful interpretation. The discussion also encompasses the broad outline of the econometric methods used to evaluate mortgage termination. Particular...

United States disequilibrium mortgage credit rationing research

The research reported here concerns studies the span both pre- and post-financial deregulation in the US. That is, they can be used to detect the impact of financial deregulation or assess the extent of credit rationing during regulated periods. Before 1983 there were restrictions on the rates charged on savings deposits. This meant that during periods when the maximum deposit rates were binding, lenders were short of funds with mortgages rationed, a process known as disintermediation. It has...

The simultaneous determination of mortgage demand and choice of mortgage instrument US

The research reported under this heading relates back to the demand for mortgage debt discussed in Chapter 2 and the possibility, raised in Chapter 7, that mortgage costs were endogenous to mortgage housing demand equations. In Chapter 2 we noted the possibility that the choice of mortgage instrument and the size of the mortgage debt might be simultaneously determined. Theoretical work has suggested the possible importance of this simultaneous determination Brueckner amp Follain 1988 Brueckner...

Prepayment specific studies

A number of empirical studies have focused upon prepayment behaviour alone Green amp LaCour Little 1999 Abrahams 1997 Quigley amp Van Order 1990 Bennet et al. 1998, 2000, 2001 . This does not mean that default is ignored entirely. For example, Green amp LaCour Little and Abrahams, assume that default patterns are modelled in the base hazard of a Cox Proportional Hazards model. Other studies offer some control by including a measure of equity, or the loan-to-value ratio, at origination Quigley...

Mortgage demand under uncertainty and mortgage contract heterogeneity

A number of models approach the choice of mortgage instrument using similar arguments to those encountered in the theoretical analysis of mortgage demand in Chapter 2. In particular, the modelling of mortgage demand under uncertainty where borrowers are risk averse. The household utility function presented in that chapter expression 2.5 included wealth and its variance. Portfolio theory stresses the covariance of asset returns. If a household is focused upon portfolio wealth and its variance -...

Empirical studies of amortisation behaviour

Empirical studies have been concerned with the choice of maturity of a mortgage and thus implicitly consider the rate of amortisation. This research has covered mortgage choices in the US Dhillon et al. 1990 , Canada Breslaw et al. 1996 and the UK Leece 1997 . For example, Dhillon et al. 1990 evaluated the choice between a 15- and a 30-year fixed rate mortgage and estimated a simple probit to represent this choice. The empirical results stress the importance of affordability and tax subsidies....

General background

For those countries with large and extensive mortgage markets, such as the United States US and the United Kingdom UK , mortgage finance can be the single most important source of personal borrowing, dominating the balance sheets of many households. Thus the size, extent and the contractual features of mortgage finance are bound to have important implications for the national economic performance of many countries, along with individual and social welfare. Given the benefits of owner...

Modelling mortgage demand under credit rationing

Most pooled cross-section research has used a simple discrete choice model such as a probit or logit specification to model the mortgage housing choices of constrained and non-constrained households. Also, most of the research has been concerned with the impact of mortgage underwriting criterion on the probability of home ownership. A comparatively neglected consideration is the nature of the interdependence of the discrete and continuous choices. That is the decision to take out mortgage debt...

Down payment constraints and mortgage demand

Housing demand has been typically analysed by treating housing as an asset Poterba 1984 . In this approach the demand for housing is based upon the user cost of owner occupation. User cost reflects the theoretical models discussed above it is the marginal rate of substitution between housing and non-housing consumption. This measure gives the amount of non-housing consumption forgone for a one-unit increase in the consumption of housing services. The trade off reflects mortgage costs, forgone...

Modelling mortgage demand under conditions of certainty

Several authors have modelled mortgage demand in the context of certainty Brueckner 1994a Jones 1993, 1994 Follain amp Dunsky 1997 Dunsky amp Follain 2000 . It is assumed that future interest rates, incomes, rates of return, housing and other asset prices are all known. Certainty models help to introduce the basic building blocks and common approaches to modelling mortgage demand, also providing some useful initial simplification and important results. They have also informed most econometric...

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...

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...