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«October 30,2009 Honorable Christopher Dodd Honorable Barney Frank Chairman Chairman Comrnittee on Banking, Housing, Cornmittee on Financial Services ...»

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Office of the Director

October 30,2009

Honorable Christopher Dodd Honorable Barney Frank

Chairman Chairman

Comrnittee on Banking, Housing, Cornmittee on Financial Services

and Urban Affairs United States House of Representatives

United States Senate Washington, DC 20515

Washington, DC 20510

Honorable Richard C. Shelby Honorable Spencer Bachus Ranking Minority Mernber Ranking Minority Member Committee on Banking, Housing, Committee on Financial Services and Urban Affairs United States House of Representatives United States Senate Washington, DC 20515 Washington, DC 20510

Dear Chairmen and Ranking Minority Members:

I Pursuant to section 1602 of the Housing and Economic Recovery Act of 2008, am pleased to submit the enclosed report titled "Default Risk Evaluation in the Single-Family Mortgage Market." The report provides a detailed summary of recent research on the underwriting of single-farnily mortgages, particularly problerns that arose during the height of the mortgage lending boom in the middle years of this decade.

The Federal Housing Finance Agency (FHFA) believes that sound underwriting is critical to the current recovery of mortgage markets and must be an essential foundation of the future prosperity of the industry. We believe the enclosed report provides useful insights for industry stakeholders and policymakers aiming to restore safe and sound underwriting practices in housing finance.

Sincerely, fo,*,J¡ Ð//t/"à Edward J. DeMarco Acting Director Attachrnent (fÐ. 202-414-3800. 202-414-3823 1700 G Street, N.W., Washington,D.C.20552-0003



October 2009 Contents Page Preface

Executive Summary


The Value of Collateral

The Borrower’s Capacity for Repayment

Securitization and Loan Credit Quality

The Effects of Lender Options

Recourse to Defaulted Borrowers

Mortgage Modifications

Externalities of Mortgage Foreclosures




[A] Kelly, Austin, “Appraisals, Automated Valuation Models, and Mortgage Default,” 2009.

–  –  –

[C] Jiang, Wei, Ashlyn Nelson, and Edward Vytlacil, “Liar’s Loan? Effects of Origination Channel and Information Falsification on Mortgage Delinquency,” September 2009.

[D] Elul, Ronel, “Securitization and Mortgage Default: Reputation vs.

Adverse Selection,” Federal Reserve Bank of Philadelphia Working Paper 09-21,

–  –  –

[E] Ghent, Andra C. and Marianna Kudlyak, “Recourse and Residential Mortgage Default: Theory and Evidence from U.S. States,” Federal Reserve Bank of Richmond Working Paper 09-10, July 7, 2009.

[F] Adelino, Manuel, Kristopher Gerardi, and Paul S. Willen, “Why Don’t Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures, and Securitization,” NBER Working Paper 15159, July 2009.

[G] Harding, John P., Eric Rosenblatt, and Vincent W. Yao, “The Contagion Effect of Foreclosed Properties.” July 13, 2009.

PREFACE This Federal Housing Finance Agency (FHFA) report fulfills the requirement of Section 1602 of the Housing and Economic Recovery Act of 2008 that FHFA conduct a study of ways to improve the overall default risk evaluation used with respect to residential mortgage loans and report to Congress on the results of that study. To aid in the preparation of the report, FHFA and the Federal Deposit Insurance Corporation’s (FDIC’s) Center for Financial Research jointly selected seven papers for a public symposium held on September 16th, 2009. This report summarizes and evaluates those papers in the context of previous research and the comments provided by discussants at that symposium. The appendices to the report provide the papers themselves.

FHFA is grateful to the FDIC’s Center for Financial Research and its director, Paul Kupiec, for co-sponsoring the September 2009 symposium. FHFA also gratefully acknowledges the contribution of Professor John Quigley of the University of California, Berkeley to the preparation of the report.

–  –  –

October 2009 3


This report reviews recent research on the methods of evaluating default risk in the market for single-family mortgages. The report is occasioned by the unusually rapid pace of technical change in the single-family mortgage industry in recent decades, the rapid expansion of that market during the early years of this century, and its subsequent collapse. Many related factors contributed to that collapse, including inadequacies in the institutional structure of the market, inaccuracies in the valuation of real property, flawed assessments of the creditworthiness of borrowers, and poor evaluations of linkages between general economic conditions and mortgage termination. Beyond those factors, widely-used benchmark scenarios for comparing mortgage performance with assumptions about worst-case economic conditions proved wildly optimistic.

Against that background, Section 1602 of the Housing and Economic Recovery Act of 2008 required the Federal Housing Finance Agency (FHFA) to conduct a study of “ways to improve the overall default risk evaluation used with respect to residential mortgage loans” and to report to Congress on the results of that study. This report fulfills that requirement. To aid in the preparation of the report, FHFA and the Federal Deposit Insurance Corporation’s Center for Financial Research jointly selected seven papers for a public symposium held in September 2009. The body of this report summarizes those papers in the context of previous research and of the comments provided by discussants at that symposium. The appendices to the report provide the papers themselves.

The papers presented at the symposium were technical in nature and dealt with quite specific aspects of the evaluation and management of risk, especially default risk, in the single-family mortgage market. The papers were distinctive in that they presented and evaluated new research about the operation of the mortgage markets rather than merely providing historical narratives of the history of the past half-decade. They were also distinctive in that the technical analyses have direct policy application.

For example, for the analysis of the valuation of housing collateral, Austin Kelly’s paper (see Appendix A) evaluates the potential benefits associated with access to the results of statistical or “automated” estimates of collateral value, as well as professional appraisals, in the origination process for single-family mortgages. In an experiment to determine the effectiveness of that supplemental information, statistical estimates of collateral value at origination were appended to mortgage origination data. It was clearly established that the additional information was useful in predicting subsequent mortgage termination, especially costly default by home purchasers. It would appear that more attention could be paid to the incorporation of such statistical information into the mortgage approval process. That additional information might be especially useful in the evaluation of applications for the refinance of mortgages on existing properties, especially when refinance includes a cash-out payment to property owners.

In the evaluation of the repayment capacity of borrowers in the single-family mortgage market, two of the papers selected for the symposium compared the experience of lenders who offered loans without the customary full documentation of the 4 creditworthiness of borrowers. The papers analyzed loans issued to borrowers on the basis of their stated incomes and assets, without documentation, or else on the basis of no stated income at all. Historically, mortgages underwritten to those underwriting standards were available to those whose incomes varied considerably over time (e.g., small-time proprietors and entrepreneurs) and who consequently obtained loans with very low loan-to-value (LTV) ratios.

The analyses, by LaCour-Little and Yang (see Appendix B) and by Jiang, Nelson, and Vytlacil (see Appendix C), clearly establish that loans for which the stated (or inferred) income of the borrower was high relative to local average income also had much higher default risks. The latter paper addressed the channels of origination as well as the documentation standard. Jiang and her colleagues reported large increases in the delinquency probabilities for low-documentation loans initiated by brokers when compared to loans initiated in-house by bankers. Jiang, et al attributed that systematic variation to differences in mortgage originator preference (banker vs. broker) between sophisticated and unsophisticated borrowers. But differences in borrower clientele do not completely explain the higher delinquency rate for broker-originated, low-documentation loans. Thus, it appears that agency problems—misalignment of incentives for brokers and bankers—played a role in the higher delinquency rates observed.

Another research paper presented at the symposium also related to the problems of agency and the alignment of incentives noted above. Elul (Appendix D) examined a large loan-level data set, analyzing the riskiness of particular mortgage products: prime fixed-rate, prime adjustable-rate, and subprime loans. For prime mortgages, the results suggested that broker-originated and low-documentation loans were riskier, as were securitized loans.

The general finding that securitization increases the likelihood that mortgages will be available to borrowers who are worse credit risks but have the same easily observable characteristics highlights the distinction between “hard” and “soft” information and the role of that distinction in assessing default risk. With a routinized channel to sell mortgages based on “hard” data that is easily verifiable, such as FICO scores, lenders have weaker incentives to invest resources to uncover “soft” information about creditworthiness (for example, employment prospects). That means that “soft” information will be under-supplied, benefiting some borrowers and mortgage holders, but harming others. Over time, if the extent of securitization based only on “hard” information increases, more of those borrowers whose “soft” information makes them less creditworthy will nevertheless obtain mortgages.

A paper by Ghent and Kudlyak (Appendix E) provides new findings about the role of delinquency judgments in affecting behavior in the mortgage market. The authors present a stylized economic model of the effect upon borrower and lender behavior in the mortgage market of a lender’s option to seek deficiency judgments in the event of a default. The model is highly stylized and specific. Yet the analysis convincingly demonstrates that the importance of recourse is not really reflected in the incidence of deficiency judgments, but rather in the effect of the threat of recourse on borrower 5 behavior and lender response. Even if lenders seldom (or never) pursue deficiency judgments in court, losses are lower when the threat of recourse can be exercised credibly.

The authors also investigate empirically the importance of the availability to lenders of recourse on the default behavior of borrowers. The statistical results indicate that the effect of the value of the default option on the probability of exercise is significantly different in recourse and in non-recourse states. Recourse clearly decreases the effect of negative equity on the probability of exercising the default option, i.e.

recourse dissuades some borrowers with negative equity from defaulting. However, the extent to which recourse offsets the effect of negative equity decreases as the value of the option increases.

The analysis establishes the importance of the threat of enforcement of deficiency judgments upon outcomes in the mortgage market—the extent of default, the type of mortgage termination, and the portfolios in which default is more likely. Those effects are large, and they persist even if the incidence of litigation to enforce deficiency judgments is neither large nor widespread.

Many have observed that the extent of renegotiation of existing mortgages in response to large reductions in asset values has been limited. When Congress established the Hope for Homeowners Program in the Housing and Economic Recovery Act of 2008, the Program elicited only a few hundred modification applications by the end of the year.

The current environment is one in which we would expect the incentives for voluntary loan modification to be stronger, however. It is widely asserted that the principal barrier to mutually beneficial renegotiation between borrowers and lenders is securitization.

When mortgages are securitized through the issuance of private-label mortgage-backed securities, the interests of owners of the various tranches of those securities are not perfectly aligned, and actions taken by the mortgage servicer need not make all investors better off without harming others.

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