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Enhancing Mortgage Credit Availability Among Underserved And Higher Credit-Risk Populations: An Assessment Of Default And Prepayment Option Exercise Among Fha-Insured Borrowers

Stuart Gabriel and Yongheng Deng
While prior analyses have provided substantial evidence of elevated default probabilities among mortgages originated to lower income, less credit worthy and minority borrowers, those risks may be offset by the reduced prepayment probabilities of those loans. To the investor in FHA-insured mortgages, such offsets could serve to appreciably reduce total loan termination risk and in so doing boost investment returns. To assess those effects, this paper employs micro-data from the FHA to estimate an option-based hazard model of the competing risks of mortgage termination. The empirical model derives from option theory and includes controls for mortgage put and call options, borrower credit worthiness, and a large number of other contemporaneous and time-invariant indicators of borrower, loan, and locational risk. Results of the analysis indicate that the elevated default probabilities of loans originated to lower credit quality and minority borrowers are more than offset by their reduced prepayment risks. The estimated cumulative probability of mortgage termination among lower credit-quality and African-American borrowers is only about three-fourths that of higher credit-quality and white borrowers, respectively. Recognition of this mortgage performance advantage should enhance the willingness of lenders and investors to originate and acquire such loans and at more competitive pricing. Findings suggest that the extension of mortgage credit to less credit-worthy and underserved borrowers, in a manner consistent with their lower termination risks, would serve to advance both their homeownership opportunities and related federal housing policy objectives.