Interest Rates and the Foreclosure Process: an Agency Problem in FHA Mortgage Insurance
Unlike private mortgage insurance that establishes a coinsurance relationship with the lender, Federal Housing Administration (FHA) insurance provides full coverage of all losses including foregone interest on defaulted loans. The foregone interest component of the indemnity is at the original mortgage contract rate. This arrangment offers lenders an opportunity to exploit changes in interest rates. Specifically, lenders have an incentive to expedite (slow) the foreclosure process when the market rate is above (below) the contract rate. If the market rate is above the contract rate, the lender will expedite the process (within the constraints of the legal requirements) and reinvest the indemnity at a higher rate. Conversely, if the market rate falls below the contract rate, the lender is better off by slowing the process (again, within the constraints of legal parameters) because the loan balance earns the higher contract rate. Evidence presented below shows that this behavior can be costly to the FHA. A 10 percent decrease in interest rates (say from 10 percent to 9 percent) costs the FHA an estimated $1,151 per claim.
Numerous examples of agency problems exist in financial contracting (see Jensen and Meckling ). In real estate contracts in particular, examples of agency problems include borrower maintenance of property facing foreclosure, covenants included in mortgages (Smith, 1982), and terms of shopping center leases (Benjamin, Boyle, and Sirmans, 1990).
Similarly, agency problems associated with insurance contracts have been noted (see Mayers and Smith, 1981). Mulherin and Muller (1988) pose an incentive conflict whereby lenders have no motivation to expend costly effort to make repairs on foreclosed properties. Mulherin and Muller (1987) note the possibility that lenders may encourage default (rather than continued performance through a workout) on a fully insured mortgage that is in danger of default. As is true of the present study, the incentive conflict results from a divergence of the market and contract rate. They conclude that a rise in the market rate will lead to more defaults as lenders seek to improve the quality of their loan portfolios. They conclude a rise in rates is, therefore, costly to the FHA. In the current study the conclusion is different since the focus is on the post-default incentive conflict. That is, given a default and a rise in rates, the lender has an incentive to foreclose as quickly as possible. A quick foreclosure minimizes the total claim including carrying costs such as property taxes, hazard insurance, maintenance expenses, and so forth. A fall in rates proves costly in our model.
This article proceeds as follows. The next section discusses the effects of the incentive conflict on the speed of the foreclosure process and the per claim loss for FHA loans. Next, data and methodology are presented. Empirical results are then followed by conclusions.
Lender's Incentives: FHA Insurance
Consider a lender holding a defaulted mortgage loan. After the foreclosure process the lender will submit a claim to the FHA for losses. (In a few cases the lender can assign the loan to the FHA which will, in turn, attempt a workout with the borrower.) Those losses will consist of two parts: foregone interest on the loan balance and property carrying costs such as taxes, insurance, and maintenance expenses. Initially, the lender will not have made expenditures for carrying costs so if the contract rate is above the market rate, there is an incentive to delay the foreclosure process. As carrying costs occur, the lender must meet these out of pocket and get reimbursed at a later date without interest, reducing this incentive to delay. Appendix A demonstrates that the strength of this incentive to delay is negatively related to the market rate of interest. …