Complex Mortgages

(This post is thanks to Editor Amiyatosh Purnanandam)

The lead article in Volume 22, Issue 6 of the Review of Finance is Complex Mortgages by Gene Amromin, Jennifer Huang, Clemens Sialm, and Edward Zhong. 

The Changing Nature of Mortgages

Mortgage products were extremely simple in the twentieth century. Borrowers only needed to choose two features of a loan: whether the interest rate was fixed or adjustable, and its maturity.  Indeed, most mortgage products were simple 30-year loans with fixed or adjustable interest rates, where borrowers made both principal and interest repayments each month for the life of the loan.

Things changed dramatically in the 21st century. Mortgage products became increasingly complex leading up to the financial crisis of 2008-09, and lenders began to offer products such as interest-only loans and negative amortization loans that allowed borrowers to defer loan payments by several years.

These such Complex Mortgage (CM) products have been criticized heavily in the popular press and policy circles as one of the main culprits of financial crisis. However, their welfare implications are not immediately obvious.  There are three non-mutually exclusive views:

  • Consumption Smoothing. One view is that complex mortgages allow financially constrained homeowners to overcome cash flow problems. Borrowers who expect their income to grow over time can afford bigger mortgages and enjoy higher welfare through these products.  
  • Consumer Obfuscation. A second is that lenders may use these complex products to prey on financially unsophisticated borrowers. Under this view, these borrowers do not fully understand what they are getting into, and they end up taking these products without fully understanding their implications. 
  • Default Option. Third, rather than being duped by the complexity, borrowers may actually exploit it.  By keeping their mortgage balance high (e.g., by not repaying the principal), they can walk away from the home if house prices fall. Such strategic default by the borrowers can be costly for the mortgage market in the presence of information and renegotiation frictions.

Who Takes Out Complex Mortgages and Why?

Before teasing out the welfare implications of these products, a key first step is to understand who took these products, and how they fared in the aftermath of the financial crisis when house prices declined by a lot.  This is what the authors study, and they find surprising results.  Contrary to the popular narrative that interest-only and negative-amortization mortgages were taken primarily by poor, unsophisticated borrowers, they shows that it is in fact sophisticated borrowers, with high incomes and credit scores, who did so. 

What were the underlying motivations behind the use of these products? The paper finds support for both the consumption smoothing and default option views. Younger borrowers, living in high price appreciation areas, are more likely to take out these products.  These are precisely the borrowers who are likely to face cash constraints at the time of buying a house, and so they benefit from mortgage products with lower cash outflows in initial years.

Investigating the default-option view, the paper shows that complex mortgage products defaulted at twice the rate of conventional fixed rate mortgages.  The paper conducts a number of empirical tests to show that it is the contract design, and not just differences in borrower and property characteristics, that drive higher default rate for complex mortgage products. Interestingly, CM products have higher default rates when the borrower has a higher loan-to-value ratio.  This result suggests that when CM borrowers stand to benefit more from default option (i.e., when the loan is large compared to the value of the house), they default more.  Many critics view higher default rates as evidence of reduced consumer welfare – lenders are offering predatory mortgages that households are unable to repay.  Instead, this paper suggests that some borrowers may have used defaults to their advantage.  They could have repaid the loan, but chose not to. 

Overall, there is ample evidence that ex-ante prime borrowers used CM products to gain consumption smoothing, and ex-post they made use of their valuable default option when house prices declined a lot.  The paper makes a compelling case for looking deeper into the role of contract design as a driver of the financial crisis and ongoing policy decisions. A lot has already been written about the role of the securitization market, subprime borrowers, and supply shocks in contributing to the financial crisis.  This paper highlights the importance of mortgage contract design, where a lot more work needs to be done.

For future work, it will be useful to focus on the relatively harder issue of welfare analysis. Should there be a role for the regulatory intervention? Are lenders properly pricing the strategic defaults by borrowers in this market? How did complex mortgage interact with the securitization market? These questions are important for both theoretical and empirical research in this area. Perhaps even more importantly, these are some of the fundamental issues in the design and regulation of mortgage markets around the world.  

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