Did Prepayments Sustain the Subprime Market

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Did Prepayments Sustain the Subprime
Market? Geetesh Bhardwajy Rajdeep Sengupta
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Introduction

• Goals of the paper
• Provide rationale behind borrower defaults on
  subprime mortgages during 2006-2007
• Determine what sustained high prepayment rates
  and why prepayment rates were so high

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Initial Observations

• Subprime originated between 98-06 had very high
  prepayment rates and spreads at least half were
  prepaid within 1st 5 years after origination
• Initial mortgage rates were substantially higher
  than prime rates (even teaser rates)
• Lower interest rates did not always provide the
  incentive to refinance
• Prepayment rates were high not just for ARMs but
  for FRMs as well.
• Prepayment rates high even before reset dates on
  hybrid-ARMs and despite prepayment penalties

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What sustained high prepayment rates?

• Competing risk hazard model to show how evolving
  house prices had a positive effect on likelihood
  of prepayment
• Rising house prices reduced the likelihood of
  default
• Ease of refinancing and low costs
• 1. Increased financial awareness
• 2. Lender competition
• 3. Financial innovations
• 4. Structural changes in the mortgage market
• Negative income shocks
• 25 more likely to refinance when liquidity is
  constrained
• Refinancing to smooth consumption
• Subprime borrowers were more likely to face
  financial distress
• Low interest rate environment, although to a
  lesser degree than anticipated

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Dominant Explanation for Subprime

• Severe weakening in underwriting standards
• Weakening of borrower quality
• Bubble thinking

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The Economics of Subprime Prepayments

• Types of prepayment
• Refinancing Two reasons to refinance
• 1. Rate refinance
• 2. Cash-out refinance
• Property Sale
• Barriers to refinancing

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The Economics of Subprime Prepayments

• Changes in mortgage underwriting
• Closely integrated to capital market
• Reduced transaction costs
• Increased prepayment speeds
• Motivation to refinance different for subprime
  borrowers
• Prime refinances 66 rate refinances and 26
  cash-out
• Subprime refinances 40 rate refinances and
  almost half cash-out
• Subprime mortgage behavior
• Less sensitive to cyclical movements in interest
  rates
• Strong incentive to refinance when credit scores
  improve
• More than 3 times as likely to have prepayment
  penalties as FRMs

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Data and Summary Statistics

• Large loan level database on subprime mortgages
  (ABS Alt-A and Nonprime Database from First
  American Loan Performance)
• Database records lender, borrower, and mortgage
  characteristics as well as repayment behavior on
  individual mortgages
• Does not record if prepayment was through a
  refinance or property sale

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Prepayment Rates by Mortgage Product Type
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Repayment Behavior of Owner-Occupied Households
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Repayment Behavior of Owner-Occupied Households
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Repayment Behavior by Product Type
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Repayment Behavior by Loan Purpose
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Observations

• Loans that register a 30-day delinquency are more
  likely to prepay than loans that record a 60-day
  delinquency
• Both 30-day and 60-day delinquencies are
  significantly higher for loans originated after
  2004.
• There is a sharp decline in prepayment rates for
  loans originated after 2004.
• Low prepayment numbers for 2007, although only
  1.5 yrs of data

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The Uniqueness of Subprime Mortgage Design

• Why were prepayment rates so high?
• Prepayments were part of mortgage design and
  essentially forced borrower to return to the
  lender to refinance at shorter intervals
• Lenders avoided exposing themselves to long-term
  contracts. This gave the lender the option to
  refinance or foreclose.
• Fully indexed rate was prohibitively high so that
  borrower had no choice but to refinance
• Products originally intended as bridge
  financing for financially distressed borrowers.
• Resulted in changes to mortgage legislation

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Historic Interest Rates on Subprime Loans
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Subprime Mortgage Design

• The notion that teaser rates were very low is
  largely untrue
• Sum of the margin and the lifetime minimum
  average not much lower than the lifetime maximum
  on the loan.
• Refinancing prevented in some cases by prepayment
  penalties. 70-80 of hybrid ARMs had prepayment
  penalties.
• Prepayment term did not expire before the reset
  date.

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Prepayment Term and Date of First Reset
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Prepayment Term and Date of First Reset

• Majority of subprime mortgage contracts were
  hybrid ARMs with teaser rates, margins, reset
  dates and prepayment penalties.
• Most reset into prohibitively high rates leaving
  borrower little choice but to refinance.
• Prepayment rates high for ARMs and FRMs as well,
  even before the reset dates on hybrid ARMs and
  despite prepayment penalties.

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What Sustained High Prepayment Rates?

• Must evaluate 3 loan options stay current,
  prepay the loan or default on the loan
• Kaplan Meier Default and Prepayment Probabilities
• Default probabilities increased progressively for
  each year in sample period
• Prepayment probabilities fall sharply for
  originations of 2004-2007

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Kaplan Meier Default Probabilities
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Kaplan Meier Prepayment Probabilities
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Hazard Function

• 3 possible outcomes (j 1,2,3)
• Borrower defaults
• Borrower prepays
• Loan stays current
• Tij Age (months)
• at which borrower i chooses event j
• Hazard function specifies the instantaneous
  probability of occurrence of event j (1,2) for
  mortgage i
• Control for characteristics of the borrower,
  lender and loan characteristics

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Principal / Value Variable
Measures the ratio of the present value of the
payments on the mortgage principal outstanding at
time t using the existing mortgage rate to that
using the current rate available on a refinance
There is an incentive to refinance if rt lt r0,
that is if PVt lt 1
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Proportional Hazard Rate Regression Prepayment
ratio for ARM2
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Proportional Hazard Rate Regression Default
ratio for ARM2
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Hazard Regression Results

• Increase in FICO scores increases prepayment
  probability and reduces default probability
• Requiring full documentation on the loan
  increases prepayment and decreases default
• Fees and points marginally increase the
  probability of prepayment and default
• Increase in house prices increases the
  probability of prepayment and reduces probability
  of default

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Hazard Regression Results

• Prepayment penalties reduce prepayment and
  increase default
• Interest volatility should reduce prepayment but
  the opposite actually happens instead
• Increase in PV annualized rate should reduce
  incentive to refinance but that is not observed
  in the data
• Unemployment rate increases the probability of
  prepayment (cash out refinance) and default

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Conclusion

• Importance of house prices
• Rise in house prices increase probability of
  prepayment while reducing probability of default
• House price appreciation on mortgages of earlier
  vintages delayed prepayment whereas appreciation
  on mortgages of later vintages increased
  prepayment speeds
• Boom in house prices was largely responsible for
  sustaining the subprime market by allowing
  distressed borrowers to prepay mortgages
• 83 of loans in 2003 were prepaid by 2007
• Shiller (2008) most important single element in
  the house price boom is the social contagion of
  boom thinking

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Questions?