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Are Underserved Borrowers Lower Risk? New Evidence on the Performance and Pricing of FHA-Insured Mortgages* (Revised)

Yongheng Deng and Stuart Gabriel
This paper estimates an option-based hazard model of the competing risks of FHA mortgage termination. Results indicate that the elevated default risks of loans originated among lower credit quality and minority borrowers are more than offset by the damped prepayment speeds of those loans, so as to result in markedly lower loan termination probabilities among underserved borrower groups. Those damped termination risks translate into sizable reductions in risk premia to investors in simulated lower credit-quality mortgage pools. Empirical findings suggest that such pooling and risk-based pricing of FHA-insured mortgages could serve to substantially reduce housing finance costs among underserved borrowers, so as to advance both their homeownership opportunities and related federal housing policy objectives.