Academic journal article The Journal of Real Estate Research

Risky Borrowers or Risky Mortgages Disaggregating Effects Using Propensity Score Models

Academic journal article The Journal of Real Estate Research

Risky Borrowers or Risky Mortgages Disaggregating Effects Using Propensity Score Models

Article excerpt

Abstract This paper examines the relative risk of subprime mortgages and community reinvestment loans originated through the Community Advantage Program (CAP). A sample of comparable borrowers with similar risk characteristics is constructed using the propensity score matching method but holding two different loan products. The findings reveal that the sample of community reinvestment loans has a lower default risk than subprime loans, very likely because they are not originated by brokers and lack risky features such as adjustable rates and prepayment penalties. Results suggest that similar borrowers holding more sustainable products exhibit significantly lower default risks.

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One major concern after the collapse of the subprime mortgage market is whether the efforts to extend credit to lower-income and minority homebuyers will fall out of favor. Different from the high-risk subprime lending, there are some special lending programs targeting low-income and minority population with safe and sound operation in the residential mortgage market, such as Community Reinvestment Act (CRA)-motivated lending. The CRA directs depository institutions to help meet the credit needs of all segments of their local communities. Studies have shown that CRA has increased the volume of lending to low- and moderate-income households (Apgar and Duda, 2003; Avery, Courchane, and Zorn, 2009), while most subprime loans were originated by lenders not covered by CRA (Avery, Brevoort, and Canner, 2007a).

What is missing in the debate on the subprime crisis is an empirical examination of the relative performance of similar borrowers holding either a typical CRArelated loan or a subprime product. Such an analysis will help inform policy by answering the question of whether CRA-type mortgages contributed significantly to the housing crisis. Since borrowers holding CRA-type mortgages generally had higher levels of credit risk, such study also helps to answer the question of whether the high default rates of subprime loans represent just the higher risk profile of borrowers holding these loans or the risky characteristics of subprime loans. Some products or features that are more prevalent among subprime loans, such as prepayment penalties, adjustable rates, and balloon payments, have been found to be associated with elevated default risk (e.g., Ambrose, LaCour-Little, and Huszar, 2005; Quercia, Stegman, and Davis, 2007; Pennington-Cross and Ho, 2010). Are the higher default rates reported in the subprime sector mainly the result of risky loan products?

This study compares the performance of subprime loans and CRA loans in a special lending program called the Community Advantage Program (CAP). Since performance differences may be due to differences in credit risk of borrowers who receive different product type, propensity score matching methods is used to construct a sample of comparable borrowers. The findings reveal that for borrowers with similar risk characteristics, the default risk will be about 70% lower with a CAP loan than with a subprime mortgage. Broker-origination channel, adjustable rates, and prepayment penalties all contribute substantially to the elevated risk of default among subprime loans. When broker origination is combined with both adjustable rates and prepayment penalties, the borrower's default risk is four to five times higher than that of a comparable borrower with a prime-term CRA mortgage. Though CAP has some program-specific characteristics, the results of this study clearly suggest that mortgage default risk cannot be attributed solely to borrower credit risk; the high default risk is significantly associated with the characteristics of loan products. Done responsibly, targeted lending programs stimulated by the CRA can do a much better job of providing sustainable homeownership for the low- to moderate-income (LMI) population than subprime lending. The results have important policy implications for how to respond to the current housing crisis and how to meet the credit needs of all communities, especially those with large fraction of LMI borrowers, in the long run. …

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