Structural Change in the Mortgage Market and the Propensity to Refinance
Bennett, Paul, Peach, Richard, Peristiani, Stavros, Journal of Money, Credit & Banking
We hypothesize that the intrinsic benefit required to trigger a refinancing has become smaller, due to a combination of technological, regulatory, and structural changes that have made mortgage origination more competitive and more efficient and have raised financial awareness of homeowners. To test this hypothesis, we estimate an empirical hazard model of loan survival for two subperiods, using a database that allows us to carefully control for homeowners' credit ratings, equity, loan size, and measurable transaction costs. Our findings strongly confirm that credit ratings and home equity have significant effects on the refinancing probability. In addition, we provide evidence that homeowners postpone refinancing in the face of increased interest rate volatility, consistent with option value theory. Finally, our results support the hypothesis that structural change in the mortgage market has increased homeowners' propensity to refinance.
A PRIMARY CONSIDERATION in the pricing of residential mortgage loan assets is prepayment risk--the premature or unscheduled return of principal to investors when homeowners move, refinance, or default. Prepayment speeds increased in the 1990s relative to the 1980s, and that increase cannot be easily explained by changes in the variables normally used to describe prepayment behavior. We hypothesize that this increase in prepayment speeds is the result of structural changes on both the demand side and supply side of the mortgage market which have reduced transactions costs or "frictions" associated with obtaining a mortgage loan. On the demand side, over the past fifteen years consumers have lived through a generally declining interest rate environment with several episodes of intense refinancing activity. This experience has likely raised the general level of awareness of the option and benefits of refinancing and so may have reduced the interest rate spread threshold that triggers a refinancing. On the supply side, over the past twenty-five years the U.S. housing finance system has undergone a fundamental restructuring such that today it is both more competitive and more fully integrated with the general capital market. Moreover, technological advances have greatly shortened the time required to underwrite a loan and have worked to reduce cross-subsidies among mortgagors.
This paper presents a formal test of the hypothesis that the propensity to refinance has increased over time due to a decline in transaction costs or "frictions," broadly defined. Conducting such a test represents a substantial challenge. A considerable body of literature has demonstrated quite convincingly that prepayment behavior in general, and refinancing behavior in particular, cannot be adequately explained by financial variables alone, but rather is strongly influenced by individual borrower and property characteristics (see Archer, Ling, and McGill 1996; Caplin, Freeman, and Tracy 1997; Peristiani, Bennett, Monsen, Peach, and Raiff 1997). These studies find that in addition to changes in interest rates and transaction costs, individual homeowners' equity and credit histories play an important role in determining the probability that a mortgage will be refinanced.
We analyze a large database of home loans that contains important information on individual borrower characteristics that contribute to prepayments. The major empirical findings of this analysis can be summarized as follows. The results reconfirm the importance of individual borrower and property characteristics in prepayment behavior. Most important, at least in terms of the goals of this paper, the analysis strongly supports the hypothesis that structural changes in the mortgage market have made homeowners more inclined to refinance in the 1990s than in the 1980s, controlling for interest rate levels and volatility, points and fees, and homeowners' equity and credit histories. In addition, we provide some suggestive--though inconclusive--evidence on the motives of homeowners who refinance multiple times. …