Factors Affecting Mortgage Defaults

My comment on Rortybomb Blog about the proposed Consumer Financial Protection Agency and subprime mortgage defaults.

There are geographical and demographic variations in certain financial product usage, sometimes even on a local level (a richer and poorer part of town). To make broad-brush statements about mortgage products defaults, one has to control for the differences of the various groups that use the products that may lead to different default rates.

A mortgage default is one of three ways to terminate a mortgage. The other two are refinancing the mortgage and selling the home. All three methods reduce mortgage payments. Homeowners who face an inability to continue mortgage payments at their current levels (potential defaults) can use any of the three methods depending on the individual circumstances. Homeowners have private knowledge about their default potential and can sell or refinance, at a lower monthly mortgage payment, to avoid default without the bank knowing of the increase in default risk.

The private knowledge also allows a homebuyer at the beginning of a home buying process to self-select and self-underwrite the type of mortgage product that is best for their situation and that reduces their default risk and cost to acceptable levels.

When a homeowner cannot qualify for a refinancing (e.g., unemployment, reduction in wages, increase in non-mortgage debt, decrease in home value requiring more equity, etc.), there is the home sale option. Selling a home is a viable solution, until home prices stop appreciating or decline. An increase in the time on the market for a home to sell also decreases the viability of home sales as a solution. When the economy slows down, unemployment increases, house price appreciation stops, home prices decline and time on the market increases. There will be an expected increase in mortgage defaults.

Mortgage defaults will increase with higher unemployment rates, declines in home values and longer time on the for sale market. Attributing different default rates to different mortgage products requires controlling for the differences across the varying products in the factors that contribute to defaults to see what, if any, incremental defaults are caused by mortgage products. For example, minorities have a much higher unemployment rate in this recession than non-minorities. Attributing an increase in mortgage defaults of minorities over non-minorities to a particular type of mortgage without controlling for the higher rate of unemployment will result in an unsubstantiated conclusion. Likewise, a greater decline in home prices in particular geographical area will increase defaults, but there may be social factors for a higher use of certain mortgage products in that area. The apparent increase in defaults will not be due to the product but will be due to the greater home price decline.

Financial product usage varies by region and demographics. Unless one controls for the default factors of the various groups that use the different products, any conclusions about mortgage products causing or increasing mortgage defaults is speculative and unsubstantiated.

The direct link to the comment is here.