A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Amromin, Gene; Huang, Jennifer; Sialm, Clemens; Zhong, Edward Working Paper Complex mortgages Working Paper, No. 2010-17 Provided in Cooperation with: Federal Reserve Bank of Chicago Suggested Citation: Amromin, Gene; Huang, Jennifer; Sialm, Clemens; Zhong, Edward (2010) : Complex mortgages, Working Paper, No. 2010-17, Federal Reserve Bank of Chicago, Chicago, IL This Version is available at: http://hdl.handle.net/10419/70583 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. 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Gene Amromin is at the Federal Reserve Bank of Chicago, 230 South LaSalle Street, Chicago, IL 60604. Email: [email protected]; Jennifer Huang is at the McCombs School of Business, University of Texas at Austin, Austin, TX 78712. Email: [email protected]; Clemens Sialm is at the McCombs School of Business, Uni- versity of Texas at Austin, Austin, TX 78712. Email: [email protected];andEdward Zhong is at the Department of Economics, University of Wisconsin-Madison, Madison, WI 53715. Email: [email protected]. 1 Complex Mortgages Abstract Complex mortgages became a popular borrowing instrument during the bullish hous- ing market of the early 2000s but vanished rapidly during the subsequent downturn. These non-traditional loans (interest only, negative amortization, and teaser mortgages) enable households to postpone loan repayment compared to traditional mortgages and hence relax borrowing constraints. At the same time, they increase household leverage and heighten dependence on mortgage refinancing to escape changes in contract terms. We document that complex mortgages were chosen by prime borrowers with high income levels seeking to purchase expensive houses relative to their incomes. Borrowers with complex mortgages experience substantially higher ex post default rates than borrowers with traditional mortgages with similar characteristics. “The availability of these alternative mortgage products proved to be quite important, and, as many have recognized, is likely a key explanation of the housing bubble.” –Ben S. Bernanke 1 Introduction Over the last decade, the residential mortgage market has experienced a significant increase in product complexity, followed by a rapid reversion back to simple products. In this paper, we study the mortgage contract choice of individual households and their subsequent default behavior. The menu of household mortgage choices in the United States was dominated for decades by fully-amortizing long-term fixed rate mortgages (FRM) and, to a lesser extent, by adjustable rate mortgages (ARM) that locked in the initial interest rate for the first five to seven years of the contract. From the vantage point of the borrower, FRM contracts preserve contract terms established at origination for the lifetime of the loan. For practical purposes, the same can be said of the prevailing ARM contracts, given the average borrower tenure at a particular house of about seven years. Knowing the monthly servicing costs and amortization schedules simplifies the household budgeting problem. The mortgage market has experienced a significant increase in product complexity in the early 2000s. The products that gained prominence during the period of rapid house price appreciation featured zero or negative amortization, short interest rate reset periods, and very low introductory teaser interest rates. We term these “complex mortgages” (CM). Figure 1 shows the proportion of fixed rate, adjustable rate, and complex mortgage products originated over the period between 1995 and 2009, as reported by LPS Applied Analytics (our primary data source described in detail below). The share of complex products in the U.S. remained 1 below 2% until the second half of 2003 before jumping to about 30% of mortgage originations just two years later. In some geographic areas complex mortgages accounted for more than 50% of mortgage originations. The complex products faded almost as quickly, declining to less than 2% of originations in 2008. Complex mortgages appear to be at the core of the recent rise and decline in housing prices. To obtain an impression of the relation between risk levels and mortgage complexity, we aggregate the loan-level data into 366 Metropolitan Statistical Areas (MSAs) and then sort all MSAs into quintiles according to the proportion of complex mortgage loans in 2004 – the first year of substantial originations of complex loans. Figure 2 summarizes the average quarterly changes in house prices for the bottom, the middle, and the top MSA quintiles. We observe that MSAs in the top complexity quintile experience stronger house appreciation before 2006 and faster depreciation after 2006. This result provides an indication that house price changes were more pronounced in MSAs with high proportion of complex loans. It also suggests the importance of understanding the reasons for CM usage and the drivers of their eventual performance. The defining feature of complex mortgages is the deferral of principal repayment. As a result, complex mortgages are characterized by low mortgage payments during the first few years of the contract, which relaxes household liquidity and borrowing constraints and enables households to take large exposures in housing assets. The lack of mortgage amortization inevitably produces two effects: a higher loan-to-value (LTV) ratio for any given path of house prices and a greater reliance on refinancing to escape increases in payments once a contract enters the amortization phase. Complex mortgages can be optimal borrowing instruments if households expect their in- come levels or housing prices to increase over time, as discussed by Piskorski and Tchistyi (2010). They can also be optimal instruments for lenders concerned with their exposure in 2 an asset bubble environment (Barlevy and Fisher (2010)). In addition, complex mortgages might also be rationally chosen by households that exhibit relatively high labor income risk and live in areas with volatile house prices. These households have an incentive to minimize the initial mortgage payments and to keep the mortgage balance relatively high because they have the option to default in case of adverse income and house price shocks. These incentives to rationally default should be particularly pronounced in non-recourse states, where lenders do not have access to the non-collateralized assets of households in case of delinquency. In this case, complex mortgages should be a hallmark of sophisticated borrowers keenly aware of the value of the default option. On the other hand, the low initial payments of complex mortgages might obfuscate the long-term borrowing costs for households, as suggested by Carlin (2009) and Carlin and Manso (2010). Lenders might have an incentive to introduce complex products to hide the actual fees embedded in financial products. Whereas it is relatively easy for a household to compare the costs of plain-vanilla fixed rate mortgages across different lenders, it is more difficult to compare complex loans that often include intricate reset schedules, prepayment penalties, and short-lived teaser interest rates. Lenders might be particularly eager to offer these products if they are confident that they can securitize these loans. In this case, we should observe that complex mortgages are taken out primarily by unsophisticated investors that do not understand the specific features of their mortgage contracts. To study the mortgage choices of households and the default experiences, we make exten- sive use of the LPS Analytics data. The database, described in detail in Section 2, contains loan level information for a large sample of mortgages in the