Modeling the Performance of FHA-Insured Loans: Borrower Heterogeneity
and the Exercise of Mortgage Default and Prepayment Options
(May 2002, 35 p.)
Although mortgage loans to lower-income and higher credit risk borrowers are characterized by
elevated default probabilities, those risks may be mitigated by their slower prepayment speeds. Loans to
higher credit risk borrowers may prepay more slowly (when prepayment option is “in the money”) owing
to difficulties in borrower access to mortgage credit, problems of mortgage qualification, limited
borrower knowledge of mortgage refinance options, or damped residential mobility. Because the
prepayment risk premium is substantial, the differentially slower prepayment speeds of loans to higher
risk borrowers may have important implications for loan profitability and for efforts to expand
homeownership among those groups.
This paper estimates an option-based hazard model to simultaneously assess the competing risks of
mortgage default and prepayment. In so doing, the analysis seeks to assess the differential default and
prepayment probabilities among higher credit risk FHA mortgage borrowers. The empirical model
derives from option theory and employs well-specified proxies for the mortgage put and call options in
the default and prepayment equations. Further, given the availability of high quality micro data, the
estimating equations control for borrower credit worthiness (credit scores) and other common
underwriting variables among the approximately 40 contemporaneous and time-invariant indicators of
borrower, loan, and locational risk.
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