An Empirical Model of Subprime Mortgage Default from 2000 to March 11, 2011

Transcription

1 An Empirical Model of Subprime Mortgage Default from 2000 to 2007 Patrick Bajari, University of Minnesota and NBER Sean Chu, Federal Reserve Board of Governors Minjung Park, University of California, Berkeley March 11, 2011 Abstract We quantify the relative importance of various drivers behind subprime borrowers decision to default. In our econometric model, we allow borrowers to default either because doing so increases their lifetime wealth or because of short-term credit constraints, taking into account that either factor by itself is su cient to induce default. Our model also incorporates various proxies for borrowers beliefs about future housing prices without imposing beliefs that are necessarily rational. According to our results, the two key drivers behind the recent increase in defaults are the nationwide decrease in home prices and the increase in the number of borrowers with poor credit and high payment-to-income ratios. We use our model to evaluate alternative policies aimed at reducing the rate of default. We thank Narayana Kocherlakota, Andreas Lehnert, Monika Piazzesi, Tom Sargent, and Dick Todd for helpful conversations. Bajari would like to thank the National Science Foundation for generous research support. Thanks also go to Sean Flynn for helpful research assistance. The views expressed are those of the authors and do not necessarily re ect the o cial positions of the Federal Reserve System. Correspondence: bajari@umn.edu; Sean.Chu@frb.gov; mpark@haas.berkeley.edu. 1

2 1 Introduction Subprime mortgage loans are made to borrowers who are more likely to default due to low credit quality or risk factors associated with the loan, such as a small downpayment. From 1994 to 2005, the share of all mortgages originated in the United States that were subprime grew from less than 5% to 20%. 1 Beginning in late 2006, the subprime sector experienced a sharp increase in delinquencies and foreclosures. In the third quarter of 2005, 3.31% of all subprime mortgages were going through foreclosure. By the second quarter of 2008, this number had grown to 11.81%. 2 The turmoil in the housing market generated broader instability in nancial markets. Many subprime originators collapsed, along with commercial and investment banks that either held or securitized the loans, including Bear Stearns and Lehman Brothers. The resulting reduction in economywide lending was linked to the worst recession since the Great Depression. This paper seeks to explain the relative importance of various drivers behind the increase in defaults among subprime borrowers, a question whose importance is underscored by the role of these defaults in catalyzing the nancial turmoil. We use a uni ed framework to assess the relative importance of four potential causes. First, we investigate the role of falling home prices. The ability to default on a loan amounts to a put option on the mortgage with a strike price equal to the negative of the borrower s equity (see Deng et al., 2000; Foster and van Order, 1985; Quigley and van Order, 1995; Vandell, 1993). When home prices fall, this option becomes more in-the-money, increasing the incentive to default. Second, when agents have dynamic incentives, lower expectations about future home prices also increase the propensity to default. When home prices are expected to appreciate less or to depreciate, the option value of default is higher due to the lower anticipated capital gains from owning the house. Unlike previous approaches, which typically impose 1 Source: Moody s Economy.com. 2 Source: National Delinquency Survey by the Mortgage Bankers Association. 2

3 full rationality along with speci c assumptions about the evolution of asset prices, our paper takes a much simpler approach by using data to construct various alternative proxy measures for people s expectations. Although not without shortcomings, our approach allows us to investigate how borrowers form expectations about the future house prices. Third, rising defaults may be explained by an increase in interest rates on outstanding mortgage contracts relative to market rates, particularly for adjustable-rate mortgages (ARMs) that became popular in recent years. The more contract rates are discounted relative to the current market rate, the less the incentive to default because a borrower who defaults would lose access to the discounted interest rate. Finally, in addition to the nancial incentives outlined above, defaults may also be driven by short-term credit constraints. Borrowers who select into subprime loans are presumably less likely than other borrowers to be able to make their monthly payments, due to insu cient income and lack of access to other forms of credit. Thus, deterioration over time in the credit quality of the average subprime borrower, perhaps due to loosened underwriting standards, could also be responsible for the recent increase in subprime defaults. Moreover, when interest rates reset for ARMs, monthly mortgage payments can rise by large amounts and make it di cult for borrowers to meet their monthly debt obligations. We build an econometric model that nests these four possibilities and thereby permits us to quantify the relative importance of each factor. The dependent variable in the model is the decision to default. Households default if either the expected utility from continuing to make mortgage payments falls below the utility from defaulting or if the household becomes credit-constrained and cannot make the payments. The former comparison is captured by an equation that depends upon current home prices, expectations about future home prices, and the interest-rate environment. A second equation captures the borrower s ability to continue making payments on the mortgage, and allows for the possibility of default due to liquidity constraints. We show that our structural equations 3

4 can be speci ed as a bivariate probit model with partial observability (Poirier, 1980). Our analysis uses a rich data set from LoanPerformance that tracks the majority of subprime and Alt-A mortgages that were securitized between 2000 and The unit of observation is an individual mortgage observed at a point in time. For each loan, we observe information from the borrower s loan application, including the terms of the contract, the appraised value of the property, the loan-to-value (LTV) ratio, and the borrower s FICO score at the time of origination. 4 We also observe the month-by-month stream of payments made by the borrower as well as whether the mortgage goes into default. We merge the LoanPerformance data with the Case-Shiller home price indices in 20 major U.S. cities. The merge allows us to track the current value of a home. Our results suggest that declining house prices and deterioration in borrower and loan characteristics a ecting borrowers ability to pay are the two most important factors behind the recent increase in subprime defaults. The e ect of declining home prices on default is substantial. For a borrower who purchased a home one year earlier with a 30-year xed-rate mortgage and no downpayment, a 20% decline in home price makes the borrower 15.38% more likely to default than an otherwise identical borrower whose home price remained stable. However, liquidity constraints are as empirically important as declining house prices: the observed increase in subprime defaults is to a large extent driven by shifts over time in the composition of loan recipients toward types that are more likely to be liquidity-constrained, such as borrowers with little or low loan documentation, low FICO scores, or high payment-to-income ratios. The impact of the payment-toincome ratio on default is especially pronounced for borrowers with low FICO scores, suggesting that lack of access to credit in case of a payment shock forces some borrowers 3 Alt-A mortgages are riskier than prime mortgages but less risky than subprime. In this paper, we use the term subprime to refer to both subprime and Alt-A mortgages. 4 According to Keys et al. (2009), FICO scores represent the credit quality of a potential borrower based on the probability that the borrower will experience a negative credit event (default, delinquency, etc.) in the next two years. FICO scores fall between 300 and 850, with higher scores indicating a lower probability of a negative event. 4

5 to default on their loans. There is a wealth of literature examining various aspects of mortgage borrowers decision to default. Some studies have focused on the put-option nature of default by characterizing how net equity or home prices a ect default rates (Deng et al., 2000; Foote et al., 2008a; Gerardi et al., 2008). Others have examined the importance of liquidity constraints and the ability to pay, as measured by borrowers credit quality (Archer et al., 1996; Demyanyk and van Hemert, 2009). We build on the literature by considering the various factors that others have proposed. However, we also depart from the literature by explicitly modeling the fact that - nancial incentives arising from the put-option nature of default are largely irrelevant to the decision-making process of households who face a short-term liquidity shock. The two are competing causes of default, and our model takes into account the fact that we as researchers do not observe which of the two underlying causes is the actual trigger in each particular case of default. Carefully distinguishing between these two causes is critical for assessing policy implications. It stands to reason that reducing the magnitude of negative net equity will not be helpful in mitigating default by borrowers whose decision to default is triggered by inability to meet monthly obligations. By quantifying the relative signi cance of each factor, our paper can provide useful input into the potential e ectiveness of various foreclosure mitigation policies. The rest of this paper proceeds as follows. In Section 2, we present a model of borrower default on mortgage loans. In Section 3, we describe the data. Section 4 presents model estimates and other empirical ndings. In Section 5, we discuss policy implications of our results. Section 6 concludes. 5

6 2 Model Our model of housing default builds on the empirical frameworks proposed by Deng et al. (2000), Crawford and Rosenblatt (1995), and Archer et al. (1996). We begin by considering a frictionless and static environment without transaction costs or credit constraints, and then incorporate expectations about home prices, interest rates, and credit constraints. 2.1 Optimal Default without Credit Constraints Let i index borrowers and t index time periods. Let V it and L it refer to the value of borrower i s home and the outstanding principal on i s mortgage at time t, respectively. We can normalize the time period in which i purchases her home to t = 0. Let g it denote the nominal rate of increase in home prices between time periods t 1 and t. Thus, V it = V i0 tq (1 + g it 0) (1) t 0 =1 That is, the current home value is the initial home value times the rate of increase in home prices between time periods 0 and t. 5 In our empirical analysis, we de ne g it using the Case-Shiller price index corresponding to the location (MSA) and tercile of the appraised value of i s house at the date of origination. Empirically, there is considerable time-series variation in V it. In general, V it > V i0 for buyers who have held their homes for many years. However, for more recent buyers it may be the case that V it < V i0 because of a nationwide decline in home prices starting in mid There is considerable crosssectional variation in the magnitude of price declines as well. For example, as of October 2009, San Francisco and Las Vegas had experienced 38% and 55% declines from their peaks, respectively, while Dallas and Charlotte have witnessed relatively at home prices 5 Because modeling the process that determines house prices goes beyond the scope of this paper, we follow the literature in treating house prices as exogenous. 6

7 (5% and 12% declines from their peaks, respectively). Moreover, the magnitude of price declines varies substantially across houses in di erent price tiers. From April 2006 to April 2008, the Case-Shiller index averaged across cities declined by 21.3% at the bottom tercile, by 18.6% at the middle tercile, and by 14.3% at the top tercile. The evolution of the outstanding principal, L it, is more complicated. Our empirical analysis makes use of the fact that in the data we observe the outstanding principal as well as a complete speci cation of the contract terms that determine how L it is scheduled to evolve Frictionless and Static Environment First consider optimal default in a static environment where borrowers have to choose between (1) paying the outstanding balance on the loan and retaining the house and (2) defaulting on the loan and losing ownership of the house. We assume that there are no transaction costs, nancial frictions, or penalties for defaulting and that borrowers private valuation of a house is equivalent to its market value V. In this extremely stylized model, borrower i will choose to default if and only if she has negative equity in the house. That is, if V it L it < 0 (2) By defaulting, the borrower immediately realizes an e ective wealth gain of L it V it. On the other hand, if V it L it > 0, then default would be suboptimal, because the borrower s overall wealth would decline by the amount of her net equity. Even this highly stylized model has testable predictions for cross-sectional and timeseries variation in default behavior. First, the model predicts that borrowers are ceteris paribus more likely to default in markets such as San Francisco and Las Vegas than in markets like Dallas and Charlotte, because homeowners in the former cities have generally 6 In principle, the fact that borrowers can make unscheduled partial prepayments implies that the actual evolution of L it may depart from the scheduled evolution. However, unscheduled partial prepayments are rare in the data, so we abstract from this possibility. 7

8 experienced larger drops in V it. Similarly, due to the recent price drops, default should be more likely for recent home buyers, whose homes are more likely to be worth less currently than at the time of purchase. Third, borrowers who have made only small downpayments (and therefore have higher L it ) ought to be more likely to default Expectations about Home Prices Economic theory suggests numerous channels by which home-price expectations in uence borrower behavior. Consider the simplest extension of the static case, whereby borrowers consider not only the current house price but also the house price in the next period. This will be true, for example, if borrowers take into account that in normal housing markets, there is typically a three-to-six month lag between when a home is listed and when the home is sold. Thus, when prices are rising, the cost of default is higher than suggested by the current value of the house. Let E[g it+1 ] represent borrower i s expectation in period t, given her current information, about the growth rate in home prices through the next period. The borrower will be able to sell the home in the next period for an expected value of V it (1 + E[g it+1 ]). If she is risk-neutral and there is no discounting, it is optimal for her to default if and only if V it (1 + E[g it+1 ]) L it < 0 (3) The model thus predicts that default will be more likely in cities where homeowners forecast steep price declines than in cities where borrowers expect prices to remain at. More generally, expectations about future states of the world are relevant because when borrowers look one or more periods into the future, the default decision is a dynamic optimization problem. Higher expectations of future housing prices increase the capital gains that would be forgone if the borrower defaulted. Higher-order moments of the evolution of home prices may also be relevant. For example, greater volatility (variance) 8

9 in home prices implies greater potential gains in housing wealth if prices go up, while the potential downside is limited by the default option. The added option value generated by higher price volatility therefore decreases the incentive to default. The inclusion of transaction costs also makes the default decision a dynamic optimization problem. For example, having a damaged credit history and not being able to buy another house incurs a heavier nancial cost when housing prices are expected to appreciate. Fully modeling the dynamic problem is beyond the scope of this paper. Instead, we capture the rst-order e ects in a reduced-form way by modifying (3) to also control for the second moment (volatility) of the housing price process, V ol[g it+1 ]: V it ( E[g it+1 ] + 3 V ol[g it+1 ]) L it < 0 (4) The terms 1, 2, and 3 to be estimated in our empirical application are free parameters that allow the default decision to depend exibly on V it, E[g it+1 ], and V ol[g it+1 ]. We include the parameter 1 because the presence of transaction costs for instance, the typical 6% commissions paid to real estate agents causes the actual value of the home to the borrower to potentially deviate from V it. Note that we diverge here from the approach taken in the real-options theory literature on mortgages (e.g., Deng et al., 2000), which typically assumes that housing prices follow a random walk with drift with a xed volatility parameter, consumers are completely rational about house prices, and housing markets are frictionless. These assumptions imply that the current value of a house is a su cient statistic for future expectations and for the impact of house prices on the borrower s incentives. By contrast, our approach allows for greater generality in the relationship between admittedly rough proxies of house price expectations and the propensity to default. The home prices in our sample were atypical, with large nationwide increases followed by decreases unprecedented in scale during the post-war period. A key empirical challenge is determining how to derive expectations of home prices from the data, which we deal 9

10 with next. Measuring Expectations about Home Prices. We construct three measures of E[g it+1 ]: one based on recent price trends (constructed from realizations of housing prices prior to t); a second that looks at future price trends (constructed from ex post realizations of housing prices, in periods after t); and a third based on the user cost of housing. The rst measure assumes E[g it+1 ] = 1 tx g i. In other words, expectations about 12 =t 11 home prices are adaptive and equal the mean rate of appreciation in the twelve months. In principle, we could use a more elaborate time series model to construct a backwardlooking measure of E[g it+1 ]. However because of the atypical movements of home prices during the latter part of our sample, we prefer a simpler speci cation in which borrowers do not place weight on observations from the distant past in forming price expectations. For our second measure, we assume E[g it+1 ] = 1 t+12 X g i. That is, households have 12 =t+1 perfect foresight about home price movements an extreme form of rational expectations and have expectations equal to the ex post realized home price appreciation in the next period. We derive our nal measure using the standard formula for the user cost of housing, which is based on the observation that in a housing market in which people can either rent or buy their homes, the marginal buyer must be indi erent between buying and renting. This implies that the user cost of homeownership must equal the annual rent: Cost of ownership = V it r rf t +V it! it V it it (r c it+! it )+V it it V it E[g it+1 ]+V it it = R it (5) In this equation, V it is the house price and R it the annual rent. risk-free rate of return at time t, and therefore V it r rf t a home. The term r rf t is the is the forgone interest from owning! it is the property tax rate, it is the e ective tax rate on income, and r c it is the contract interest rate. The term V it it (r c it +! it ) represents savings to the homeowner 10

11 due to the tax-deductibility of mortgage payments and property taxes. The term it represents the depreciation rate of the house, V it E[g it+1 ] the expected capital gain, and it the risk premium. Using observed values of V it, R it, r rf t,! it, it, rit, c it, and it, we can impute expected housing price appreciation by solving for E[g it+1 ]: E[g it+1 ] = r rf t +! it it (r c it +! it ) + it + it R it V it (6) Himmelberg et al. (2005) impute E[g it+1 ] using equation (6) and report a closely related measure in their paper, which we use in our empirical model. See Himmelberg et al. (2005) for more details. Similar to E[g it+1 ], there are di erent potential ways to construct V ol[g it+1 ], our measure of housing price volatility. However, for simplicity we use a backward-looking measure, namely, the variance of g it over the previous twelve-month period Interest Rates We also allow the optimal default decision to depend on interest rates. Theory predicts that when market interest rates are high relative to the contract rate, the incentive to default is lower. If the contract rate is less than the current market rate available to the borrower, default implies losing the future value of the discount. Following Deng et al. (2000), we compute the normalized di erence between the present value of the payment stream discounted at the current market interest rate and the present value discounted at the contract rate. For borrower i in period t, de ne IR it = TP M it P it (1+rit m=1200)t0 t 0 =1 TP M it t 0 =1 TP M it P it t 0 (1+r c =1 it =1200)t0 = P it (1+rit m=1200)t0 TP M it 1 (1+rit m=1200)t0 t 0 =1 TP M it t 0 =1 TP M it 1 t 0 (1+r c =1 it =1200)t0 (7) 1 (1+rit m=1200)t0 11

12 In (7), the term P it is the monthly payment for the mortgage, T M it is the number of remaining months until maturity, r m it is the market rate for i at time t, and r c it is the contract rate. 7 Note that IR it is an increasing function of r c it, a decreasing function of r m it, and an increasing function of T M it if r c it > r m it. A higher value of IR it implies a stronger incentive to default. Accounting for IR it yields the optimal default rule V it ( E[g it+1 ] + 3 V ol[g it+1 ]) L it (1 + 4 IR it ) < 0 (8) The market interest rate r m it varies across households because of di erences in credit histories and other risk factors, but is not directly observed in our data. Fortunately, the LoanPerformance data cover a large majority of all subprime mortgage originations and provide detailed borrower characteristics. We can therefore form a very precise estimate of rit m that controls for both observed and unobserved household-level heterogeneity. Details behind our procedure for estimating rit m are described in Appendix A. We would ideally also like to control for expectations about interest rates, just as we control for house price expectations. Doing so in a structural way is di cult. However, we do incorporate one prominent source of interest rate changes: rate resets for ARMs. If a borrower expects that her contract interest rate will reset to a higher level in the near future, she will have, ceteris paribus, a stronger incentive to default. Let MR it denote the number of months before the next rate reset for borrower i in period t. 8 We can then write the default decision as V it ( E[g it+1 ] + 3 V ol[g it+1 ]) L it (1 + 4 IR it + 5 MR it ) < 0 (9) 7 For adjustable-rate mortgages, P it and rit c may vary over the course of the loan, but for simplicity, we assume that P it and rit c remain constant at the levels for the current month t. We also assume that rit m remains constant at the level for the current month t. 8 For xed-rate mortgages, we set MR it =0 and then include a separate dummy for xed-rate mortgages. 12

13 2.2 Liquidity Constraints In the model developed so far, borrowers default whenever doing so increases their wealth a characterization of behavior that is referred to in the mortgage literature as ruthless default (Vandell, 1995). The literature has found that the ruthless default model provides an incomplete explanation of borrower behavior. Previous authors have argued that liquidity constraints and limited access to credit are also important explanatory variables behind default behavior in mortgage markets as well as in credit markets more generally (Adams et al., 2009; Deng et al., 2000; Kau et al., 1993). In this section, we consider two mechanisms by which illiquidity may trigger default. The rst is that default is triggered by interest rate resets, which increase monthly payments. The second explanation considers the role of credit constraints. In the popular press, an often-cited reason for the increase in borrower default rates is that homeowners have insu cient income to make their mortgage payments following an interest rate reset. For example, on a $300,000 ARM with a 30-year term, an increase in the interest rate from 9% to 11% generates an increase of over $400, or a 15% increase, in monthly payments. This sharp increase in mortgage payments makes it di cult for the household to service its debt in addition to paying for other household expenditures. To formalize this story, let P it denote i s mortgage payment, C it the consumption of a composite commodity, and Y it income. Household i s budget constraint at time t can then be expressed as P it + C it Y it (10) A household would then be forced to default if it is unable to simultaneously make its mortgage payment P it and purchase C it. The budget constraint (10) assumes that household i is in a state of autarky, with no savings or access to credit outside the mortgage market. We can relax this assumption by allowing households to tap into savings or access other forms of credit. The amount 13

14 household i can borrow depends on its creditworthiness and future income (for theoretical discussions, see Aiyagari, 1994; Deaton, 1991; and Chatterjee et al., 2007). Let Z it be a vector of covariates predicting the household s creditworthiness, future income, or assets other than the house. Consider the following modi cation of (10), which incorporates these shifters: 0i + 1 Z it + 2 P it Y it + 3 Z it P it Y it 0 (11) Note that if we assume household i s consumption is constant over time as a proportion of income, then this modi ed speci cation generalizes the previous formulation. This can be seen by dividing both sides of (10) by Y it and rearranging terms, with C it Y it by the term for household-level heterogeneity ( 0i ) in (11). ratio C it Y it being captured This assumption of a xed abstracts from the possibility of substitution between consumption of housing and other goods, but it is not a critical assumption. This new budget constraint nests various liquidity-related triggers of default. The parameters 1, 2, and 3 allow us to exibly model i s budget constraint as a function of the payment-to-income ratio P it Y it through P it Y it, and the interaction term Z it P it Y it and covariates Z it. The e ect of interest rate resets enters allows for the possibility that an increase in the payment-to-income ratio has a bigger impact on certain types of borrowers. 2.3 Empirical Framework Equations (9) and (11) represent two drivers of default: borrowers default either because doing so increases their wealth or because credit constraints bind. In other words, a household s optimal decision rule takes the form of a system of two inequalities. As econometricians, we only observe whether a given household defaults in each period t. When we observe default, we do not know whether it is due to (9), (11), or both. We formulate our econometric model by de ning two latent utilities, U 1;it and U 2;it, 14

15 constructed from the left-hand sides of expressions (9) and (11) with the addition of stochastic errors " 1;it and " 2;it. For household i at time t: U 1;it = 0i + V it L it ( E[g it+1 ] + 3 V ol[g it+1 ]) U 2;it = 0i + 1 Z it + 2 P it Y it ( 4 IR it + 5 MR it ) + " 1;it (12) P + 3 Z it it Y it + " 2;it U 1;it represents the latent utility associated with not defaulting. The term " 1;it is an iid shock and represents idiosyncratic di erences across borrowers and time in their utility from not defaulting. U 2;it represents the budget constraint of household i at time t, and " 2;it is an idiosyncratic shock to the tightness of the household budget constraint. The terms U 1;it and U 2;it are correlated with each other through the observable covariates V it, L it, E[g it+1 ], V ol[g it+1 ], IR it, MR it, P it Y it, and Z it, as well as through the distribution of the unobservables " 1;it and " 2;it. We assume " 1;it and " 2;it are jointly normal with a variance of 1 and a exible covariance. The terms 0i and 0i capture time-invariant, unobserved borrower heterogeneity in U 1;it and U 2;it. For instance, 0i captures any di erences across borrowers in the degree of emotional attachment to their homes. On the other hand, if borrowers di er in their access to informal sources of credit (such as other family members), such a di erence is captured by 0i. Accounting for such unobserved heterogeneity is important for robustness. We de ne the outcome as the random variable ND it, which equals 1 if household i does NOT default in period t and equals 0 otherwise. Normalizing the outside options for both U 1;it and U 2;it to zero, the condition for default is as follows: ND it = I(U 1;it 0) I(U 2;it 0) = 0; ) Default, fu 1;it < 0 or U 2;it < 0g (13) where I() is an indicator function. From the data, we observe the value of ND it. However, when default occurs (ND it = 0) we do not observe whether it is because U 1;it < 0, because U 2;it < 0, or both. 15

16 This data-generating process corresponds to a bivariate probit model with partial observability (Poirier, 1980). By modeling default as the outcome of a two-equation model, our approach contrasts with the existing literature, in which researchers have typically included in a single equation both the determinants of nancial incentives and measures of liquidity (Archer et al., 1996; Demyanyk and van Hemert, 2009). A singleequation model fails to account for the fact that the nancial incentives are relevant for default decisions only if the liquidity constraint does not bind, and vice versa. Among the covariates Z it entering the liquidity equation, we include direct measures of creditworthiness such as the FICO score and the monthly unemployment rate at the county level, which proxies for household unemployment. We also include observable loan characteristics at origination, which proxy for selection e ects due to heterogeneous borrowers sorting into di erent types of loan products. Among these product characteristics we include the level of documentation for the loan application and the loan-to-value ratio at origination. 9 These variables do not necessarily have causal e ects on the likelihood of being liquidity-constrained, but borrowers with di erent propensities to become illiquid are likely to be matched with loans that di er along these dimensions. For example, borrowers who choose loans requiring little documentation of income or wealth are more likely to have low credit and liquidity problems. Similarly, loans with higher loan-to-value ratios at origination are more likely to attract illiquid borrowers, many of whom would have been unable to obtain loans under tighter terms. In principle we could specify the borrower s decision as a choice among three options by distinguishing between prepayment and regular continuation of scheduled payments. In the above baseline speci cation, the choice of no default includes both prepayment as well as the decision to make only scheduled payments. Therefore, if certain factors in uence both default probability and prepayment probability, our coe cient estimates capture only the net e ect. To see whether our key ndings are sensitive to this modeling choice, 9 Note that the loan-to-value ratio at origination can reasonably be excluded from the rst equation U 1;it after controlling for the current loan-to-value ratio. 16

17 we also estimate an alternative model in which prepayment and default are competing hazards. As an additional check, we also estimate the baseline model after dropping all loans ending in prepayment. We must provide two caveats about the empirical speci cation. First, one of our key goals is to explicate an e ect that has received little attention in the past: namely, default can be triggered by one of two competing forces even when a loan is sound along the other dimension. However, distinguishing between nancial incentives (Eqn. 1) and credit constraints (Eqn. 2) is in some senses somewhat arti cial. Namely, short-term illiquidity may raise a household s marginal rate of substitution between current and future consumption and thus increase the nancial incentive to default. There are also potential linkages between the current state of a household s nancial variables and the household s access to credit. For example, it is generally easier for households to obtain a homeequity loan when they have more equity in the house. These issues notwithstanding, as a conceptual matter, it is still crucial to distinguish between and understand the relative importance of liquidity versus long-term nancial incentives. A second caveat is that we do not perfectly observe a borrower s liquidity at a point in time. For example, as we discuss in the next section, we only know a borrower s income at the time of origination. This imperfect observability of contemporaneous determinants of liquidity is less than ideal, but is prevalent throughout the literature. The main implication is that we must exercise the same degree of caution in interpreting our estimates as is warranted by the problem of omitted variables in the empirical mortgage literature more generally. 3 Data Our estimation uses data from LoanPerformance on subprime and Alt-A mortgages that were originated and securitized between 2000 and The LoanPerformance data set 17

18 covers more than 85% of all securitized subprime and Alt-A mortgages. According to the Mortgage Market Statistical Annual, 55%-75% of all subprime mortgages were securitized in the early- to mid- 2000s. Because sample selection is based on securitization, our sample may di er from the subprime mortgage market as a whole. For each loan, we observe the loan terms and borrower characteristics reported at the time of origination, including the identity of the originator, the type of mortgage ( xed rate, adjustable rate, etc.), the frequency of rate resets (in the case of ARMs), the initial contract interest rate, the level of documentation (full, low, or nonexistent 10 ), the appraisal value of the property, the loan-to-value ratio, whether the loan is a rst lien, the location of the property (by zip code), the borrower s FICO score, and the borrower s debt-to-income ratio. We exclude from our sample exotic mortgage types such as interestonly or balloon loans, and focus on standard xed- and adjustable-rate mortgages. We further restrict our sample to rst liens. See Table 1 for variable de nitions. The data also track each loan over the course of its life, reporting the outstanding balance, delinquency status, current interest rate, and scheduled payment in each month. We de ne default as occurring if either the property forecloses or becomes real-estate owned. Default is a terminal event, so if a loan defaults in month t, the loan is no longer in the sample starting from month t + 1. One important time-varying variable that enters into the liquidity equation (11) is the payment-to-income ratio, P it Y it. While we do not observe income at the household level in each month, we can impute household income at the time of origination based on the reported front-end debt-to-income ratio. 11 The front-end debt-to-income ratio is available only for a very small fraction (3.5%) of all loans, signi cantly reducing our sample. To see if our results are sensitive to this 10 Full documentation indicates that the borrower s income and assets have been veri ed. Low documentation refers to loans for which some information about only assets has been veri ed. No documentation indicates there has been no veri cation of information about either income or assets. 11 Speci cally, we assume that household income stays constant over time, and we impute the income by dividing the initial scheduled monthly payment by the reported front-end debt-to-income ratio. The front-end ratio is de ned as total housing-related principal and interest payments, taxes, and insurance as a percentage of monthly income. 18

19 sample restriction, we also construct an alternative imputation of household income based on the back-end debt-to-income ratio, 12 which is available for 63% of all loans and therefore permits a more representative estimation sample. Our estimation results are similar across the two samples, so throughout this paper we focus on results based on the subsample for which income can be constructed from the front-end ratio. 13 For more detailed discussions of the LoanPerformance data, see Demyanyk and van Hemert (2009) and Keys et al. (2009). Because the LoanPerformance data do not report borrowers demographic characteristics, we match the loan-level data to 2000-Census data on demographic characteristics at the zip-code level (per-capita income, average household size and education, racial composition, etc.). In addition, we utilize monthly unemployment rates reported at the county level by the Bureau of Labor Statistics. These variables proxy for individual-level demographics and employment status. To track movements in home prices, we use housing price indices (HPI) at the MSA level from Case-Shiller, which cover 20 major MSAs. 14 The HPI for each MSA is normalized to 100 for January The home price indices are reported at a monthly frequency, and are determined using the transaction prices of the properties that undergo repeat sales at di erent points in time in a given geographic area. In addition, for 17 out of the 20 MSAs covered by Case-Shiller, the HPI is broken into three price tiers low, medium, and high depending upon the quantile of the rst transaction price of the property within the distribution of all observed transaction prices occurring during the 12 Similar to the front-end ratio, the back-end ratio measures the household s monthly debt burden relative to income. However, the back-end ratio is more comprehensive and includes not only mortgage-related debt payments in the numerator, but also car loans, student loans, and minimum monthly payments on any credit card debt. Because we lack data on the borrower s non-mortgage debt, the income imputation based on the back-end debt-to-income ratio is noisier than the imputation based on the front-end debt-to-income ratio. 13 All unreported results in the paper are available from the authors upon request. 14 Cities covered by Case-Shiller are Atlanta, Boston, Charlotte, Chicago, Cleveland, Dallas, Denver, Detroit, Las Vegas, Los Angeles, Miami, Minneapolis, New York, Phoenix, Portland, San Diego, San Francisco, Seattle, Tampa, and Washington D.C. 19

20 period of the rst sale. 15 We use the tier-speci c HPI in constructing V it, E[g it+1 ], and V ol[g it+1 ] for the 17 MSAs for which it is available. For the remaining three MSAs, we use the MSA-level HPI. Table 2 reports summary statistics for key variables. We report separate summary statistics according to the mode by which loans come to an end in the sample by prepayment, by default, or by either maturation or censoring at the end of the sample. Within the last category, virtually all of the loans are censored, so in the following discussion, we shall simply refer to the third category as the censored observations. The raw relationships between the termination mode and measures of borrowers ability to pay are generally consistent with our hypotheses. Loans that default tend to be adjustablerate mortgages and are associated with higher initial loan-to-value ratios and lower credit scores. For instance, the average FICO score in the sample is 623, compared with an average of 584 conditional on default. The second panel of Table 2 presents summary statistics for time-varying variables in the last period in which we observe each loan. Relative to the overall average across all borrowers, borrowers that default tend to have less equity as well as higher payment-toincome ratios at the time of default. log(v=l) is on average in the last observed period, but the average is somewhat higher conditional on prepayment (0.524) and much lower for loans that default (0.361). The monthly payment-to-income ratio is on average in the nal period, and tends to be highest among loans that default (0.345), somewhat lower among loans that prepay (0.320), and lowest among the censored loans (0.281). 15 The three MSAs lacking tier-speci c price indices are Charlotte, Dallas, and Detroit. 20

21 4 Results For robustness, we consider a wide range of alternative speci cations. In all cases, the dependent variable is default or no default in a given month. Table 3 presents the coe cient estimates and marginal e ects for the baseline case, in which we set the constant terms to be 0i = 0 and 0i = 0 for all households. We add household-level random e ects in Table 4. For each speci cation, the column labeled Eqn 1 reports the parameter estimates for covariates that determine U 1;it in equation (12). The column labeled Eqn 2 reports parameters for covariates that determine U 2;it. In Table 5, we display estimates of the change in the probability of default in a given month due to an increase in each independent variable by one standard deviation, divided by a baseline default probability obtained by setting all explanatory variables equal to their mean values conditional on eventual default. 16 Speci cation 1 in Table 3 is a parsimonious version in which U 1;it is only determined by the ratio of the home value to the outstanding loan balance. The discussion in Section suggests that the incentive to default decreases as this ratio increases. In our empirical analysis, we take the natural logarithm of this ratio, because the denominator can be very close to zero for loans nearing maturity. Taking the log transformation prevents these observations from having unduly large in uence on our estimates. Consistent with the predictions of Section 2.1.1, estimates from this minimal speci - cation indicate that borrowers with a lower value-to-loan ratio are more likely to default. The marginal e ects imply that a one-standard-deviation increase in log( V ) is associated L with a 24.22% reduction in the hazard of default in a given month. This suggests that the sharp decline in home prices played an important role in the recent increase in foreclo- 16 We express all marginal e ects as the e ect on the probability of no default, P (U 1 0; U 2 0), with all independent variables set at their mean values conditional on eventual default. We evaluate the marginal e ects at the mean values conditional on eventual default instead of using the more conventional approach of evaluating at the unconditional sample mean because the probability of default in a given period is very low, causing numerical problems when we try to compute the marginal e ects at the unconditional sample mean. 21

22 sures. Consider a hypothetical household in Phoenix that purchases a home in February 2007 with a 30-year xed-rate mortgage and no downpayment, implying log( V L ) = 0 at the time of purchase. Further, assume that the household makes payments such that the outstanding balance on the loan in February 2008 is of the original loan amount. If there is no change in home price between February 2007 and February 2008, the household s log( V ) in February 2008 would be During this time period, however, actual L home prices in Phoenix fell by 21.7%. If this hypothetical household s property value experienced the actual average home price change in Phoenix, its log( V ) at the end of this L time period would be Thus, the decline in home price would make the household 16.9% more likely to default in February 2008 compared to the hypothetical case of no change in home price. The estimated impact of log( V ) decreases when we add MSA- L and year xed e ects (Speci cation 4), because these xed e ects soak up some of the variation in home prices. However, we still nd that net equity in the property plays an important role in default decisions. According to Speci cation 4, a one-standarddeviation increase in log( V ) is associated with a 7.55% lower hazard of default even after L we control for the expected home price appreciation in the next period, E[g it+1 ]; price volatility, V ol[g it+1 ]; and MSA- and year xed e ects. As we would expect based on our discussion in Section 2.2, an increase in the ratio of monthly mortgage payments to monthly income predicts an increase in the probability of default. According to Speci cation 1, a one-standard-deviation increase in this ratio is associated with a 17.15% greater hazard of default. This relationship implies that interest rate resets for ARMs contributed to the increase in foreclosures by making borrowers monthly payments less a ordable. For Speci cations 2 4 of Table 3, we interact the ratio with the borrower s credit score and nd that the e ect is stronger for borrowers with low or medium credit than for those with high credit. This nding is consistent with the idea that liquidity constraints are less severe for high-credit households because they have greater access to the capital market. 22

23 Estimates for the other liquidity covariates have sensible values. A one-standarddeviation increase in the uninteracted FICO score about 74 points corresponds to a decrease in default probability of percentage points (for Speci cation 1), or 77.09% of the hazard. A borrower with a second lien is % more likely to default than an otherwise identical borrower whose property has only one mortgage on it. Consistent with our discussion in Section 2.2, loan characteristics proxying for borrower creditworthiness are also important drivers of default. According to Speci cation 1, a low-documentation loan has a 0.3 percentage point higher chance of default in a given month, or equivalently, a 39.81% greater hazard of default compared with a full-documentation loan. Similarly, a one-standard-deviation increase in the original loan-to-value is associated with a 21.52% greater hazard, and a one-standard-deviation increase in the local unemployment rate is associated with a 10.09% greater hazard. The magnitudes of these estimates do not vary much across Speci cations 1-4. Following the discussions in Sections and 2.1.3, Speci cations 2 4 of Table 3 also include additional determinants of the nancial incentive to default in the equation for U 1;it namely, E[g], V ol, IR, and MR. All of the speci cations in Table 3 use the backward-looking measure of house price appreciation (Exp_Bwd). Speci cation 4 is the most comprehensive speci cation, and includes the loan age, local demographics, MSA dummies, servicer dummies, and year xed e ects. The estimates from Speci cations 2 4 suggest that expectations of higher house price growth, measured by Exp_Bwd, reduce the nancial incentive to default. For instance, the estimates from Speci cation 4 imply that in markets where housing prices have been appreciating at an annual rate 10% above the sample average, the hazard of default is 4.22% lower than for an otherwise identical borrower in an average housing market. In addition, the estimates show that expectations about home price volatility also a ect default behavior. When we include the volatility of housing prices over the previous 23

24 twelve months, V ol, 17 along with its interaction with log( V ), the uninteracted term has L almost no e ect, but the interaction decreases the propensity to default. Speci cally, at the average level of log( V ), a one-standard-deviation increase in the volatility measure is L associated with a 2.77% lower hazard of default, according to our Speci cation 4 results. Our ndings are thus consistent with the notion that volatile home price movements increase the option value maintained by not defaulting, but primarily for borrowers with higher net equity. While we cannot provide a de nitive explanation for the di erential e ect, one conjecture is that risk aversion declines with wealth: if households with greater net equity also tend to be wealthier overall, the option value generated by volatility would be greater for households with more net equity. The estimates of the e ect of interest rates are weak but consistent with model predictions. We nd that IR (our measure of how overpriced contract interest rates are, relative to the market rate) has almost no e ect on the probability of default. This is most likely because high contract interest rates increase both the incentive to prepay and to default, combined with the fact that prepayment is classi ed under the category of no default in our speci cations. As expected, ARMs are riskier. All else equal, ARMs have a 12% greater hazard of default, following Speci cation 4. Among ARM-holders, default is also more likely when rate resets are imminent: each additional eleven months between the present period and the next reset lowers the hazard of default by about 1.34% (Speci cation 4). Finally, the parameter estimates for Loan Age and (Loan Age) 2 indicate that over the life of a loan, there is an initial increase in the probability of default, but after the rst three years, older loans are much less likely to default conditional on survival. This humpshaped hazard pro le is consistent with the ndings of other researchers (Gerardi et al., 2008; von Furstenberg, 1969). In theory, this e ect could be explained by unobserved 17 Since Exp_Bwd is de ned as housing price growth rate over the previous 12 months and V ol is de ned as the standard deviation of home prices over the previous 12 months (divided by 10), the volatility measure re ects how evenly home prices move around the overall trend. 24