First-Time Homebuyers, You’re Okay

Couple Looking at Home

Saty Patrabansh of the Office of Policy Analysis and Research at the Federal Housing Finance Agency has posted a working paper, The Marginal Effect of First-Time Homebuyer Status on Mortgage Default and Prepayment.

While this is a dry read, it yields a pretty important insight for first-time homebuyers: you’re okay, just the way you are! The abstract reads,

This paper examines the loan performance of Fannie Mae and Freddie Mac first-time homebuyer mortgages originated from 1996 to 2012. First-time homebuyer mortgages generally perform worse than repeat homebuyer mortgages. But first-time homebuyers are younger and have lower credit scores, home equity, and income than repeat homebuyers, and therefore are comparatively less likely to withstand financial stress or take advantage of financial innovations available in the market. The distributional make-up of first-time homebuyers is different than that of repeat homebuyers in terms of many borrower, loan, and property characteristics that can be determined at the time of loan origination. Once these distributional differences are accounted for in an econometric model, there is virtually no difference between the average first-time and repeat homebuyers in their probabilities of mortgage default. Hence, the difference between the first-time and repeat homebuyer mortgage defaults can be attributed to the difference in the distributional make-up of the two groups and not to the premise that first-time homebuyers are an inherently riskier group. However, there appears to be an inherent difference in the prepayment probabilities of first-time and repeat homebuyers holding borrower, loan, and property characteristics constant. First-time homebuyers are less likely to prepay their mortgages compared to repeat homebuyers even after accounting for the distributional make-up of the two groups using information known at the time of loan origination.

So, just to be clear, being a first-time homebuyer is not inherently risky. Rather, the risks arising from transactions involving first-time homebuyers are the same as those involving repeat homebuyers:  loan characteristics, property characteristics and other borrower characteristics.

Wednesday’s Academic Roundup

Wednesday’s Academic Roundup

Kroll on Mortgage Performance

The Kroll Bond Rating Agency has issued an update of its residential mortgage-backed securities model methodology, Residential Mortgage Default and Loss Model. Before the financial crisis, ratings models seemed to be very reliable, data-driven models of probity and caution. We have since learned that different mortgage vintages (the year of origination) can behave very differently and ratings models could be based on simplistic assumptions. Hopefully, the updated Kroll model does not suffer from those flaws, although their key takeaways seem pretty basic to me:

  • Underwriting standards are the fundamental determinant of mortgage quality.
  • Negative home equity creates a major incentive for borrower default, resulting in substantial credit loss.
  • Credit scores continue to have value as a relative indicator of risk.
  • Inflation of real home prices above the long-term mean is unsustainable and represents increased credit risk. (4-5)

Kroll’s update does include some interesting revisions, including,

Reduced default expectations for purchase loans. It has long been observed that purchase loans generally have lower default risk than refinancings, all else being equal. This is attributed to the fact that a purchase represents an actual arms-length transaction which yields a more accurate view of a home’s value than an equivalent refinancing transaction. However the pre-crisis mortgage vintages showed high levels of default associated with purchase mortgages. This was largely due to the practice of extending credit to first time homebuyers, often on very favorable terms despite these borrowers having little credit history or poor credit history. This poor performance by purchase loans was reflected in the historical data regression analysis used to develop the RMBS model.

Based on analysis focused on both jumbo and conforming prime mortgages, KBRA has found that, for these loans, the traditional benefits of purchase loans remain well established, and we have adjusted the model ‘s treatment of purchase loans to reflect lower default expectations relative to equivalent refinancing mortgages. This revision is effective with the publication of this report.

*     *     *

Penalty for high debt-to-income (DTI) loans. While the KBRA RMBS model does not contain a specific risk parameter based on DTI, it is our opinion that very high DTI loans can bear significant incremental risk. When we began to encounter newly originated loans with back-end DTIs in excess of 45%, we assigned an additional default penalty to such loans. This has been documented in presale reports for those rated RMBS backed by loans with high DTIs. (3)

Time will tell if Kroll got it right . . ..

Tall Mortgage Tales

Todd Zywicki has posted The Behavioral Law and Economics of Fixed-Rate Mortgages (and Other Just-So Stories) to SSRN. The article contains

SPOILER ALERT!

a spoof, in order to make a larger point.

The abstract reads,

A major cause of the recent financial crisis was the traditional American mortgage, which is distinctive for the following features: it is a thirty-year, self-amortizing loan with an unlimited right to prepay. The United States is unique in the world for standardizing on a mortgage product with these features. Yet not only have a majority of the foreclosures that occurred during the financial crisis been fixed-rate mortgages, the fixed-interest-rate characteristics have undermined efforts by the Federal Reserve and government to assist recovery of the housing market. Moreover, the long fixed-rate term and ability to refinance are highly expensive and suboptimal features for many consumers. Nevertheless, many consumers persist in purchasing this mortgage. Drawing on the methodology of behavioral law and economics, this article provides rationalizations for how behavioral law and economics can explain the persistence of a product that is so harmful to many consumers and to the economy at large. The article then draws conclusions about what this analysis means for the behavioral law and economics research program generally and for the use of behavioral law and economics in government policymaking.

 I have a lot to say about this article but I don’t want to ruin it for you!  Suffice it to say, the article is a provocative critique of behavioral law and economics. Those of us who hope to see a healthy mortgage market develop would do well to take this critique seriously — even if you end up rejecting its broader implications.