2002
Abstract:
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.
