IS A VARIABLE MARTURITY MORTAGE SAFE?

Is a Variable Maturity Mortgage a safe instrument for Poor Households? Brock Lacy London School of Economics and Political Science

IS A VARIABLE MARTURITY MORTAGE SAFE?

Abstract This paper examines the Variable Maturity Mortgage (VMM) which has been has been touted as a means to extend homeownership opportunities to low income borrowers. This proposition is tested using Vandells respecification method. The VMMs performance is simulated using historical data for a US real estate market, namely Utah. The VMMs default risk is then measured against the Fixed Rate Mortgage (FRM). I contend that the VMM carries more risk relative to the FRM, and therefore the FRM is still the safer mortgage.

IS A VARIABLE MARTURITY MORTAGE SAFE?

I.

Introduction

In the article, Three Initiatives Enhancing the Mortgage Market and Promoting Financial Stability the authors examined instruments which they deemed, as initiatives to improve the mortgage market (Hancock and Passmore, 2009). One of these initiatives was the Variable Maturity Mortgage (VMM) or as it is called in Hong Kong, the Variable Rate Tenor Mortgage (Chow et al., 1999). The VMM has been used extensively in Hong Kong and existed prior to the subprime mortgage crisis in the US, however according to Chow and Liu (2002), this type of mortgage has never played a major roleand it is usually treated as another variant of the Adjustable Rate Mortgage (ARM) (Chow and Liu, 2002)(p.62). The VMMs payments are fixed; however its time to maturity is adjustable at reset intervals, thus it can be view as a blend of the FRM and the ARM. In the Hancock and Passmore (2009) paper, the VMM was heralded as a potential means to extend credit and home ownership opportunities to poor households. I submit that prior to endorsement to this end; the VMM should be simulated to discover its default risk behavior in a US market. My hypothesis is thus: the VMM is considerably more risky than the FRM especially for poor households. To test my hypothesis I will simulate the riskiness of the VMM relative to the FRM in the Utah state real estate market. The results suggest that although there

IS A VARIABLE MARTURITY MORTAGE SAFE?

are advantages to the VMM for poor households, there are still considerable risks if households require low levels of equity to finance a real estate purchase, and therefore the FRM remains the safer instrument.

II.

Literature Review

One of the first empirical studies of the determinants of default risk was conducted by Von Furstenberg (Von Furstenberg, 1969). Using Ordinary Least Squares (OLS) analysis he found that initial loan to value ratio (LTV), and age of the mortgage (AGE) were significant determinants of default risk. LTV is an inverse measure of equity, and the preeminent effect of equity on default risk has been supported by copious empirical research (Capozza et al, 1997) (Demyanyk et al, 2011) (Pennington-Cross and Ho, 2006) (Deng et al, 1999). Von Furstenberg also found that AGE acts as a, seasoning on default risk (Von Furstenberg and Green, 1974), meaning that mortgage default rates are increasing through the first three to four years and then decreasing thereafter. This effect has been supported by additional research (Von Furstenberg, 1969) (Von Furstenberg, 1970a) (Von Furstenberg, 1970b) (C.L. Foote et al, 2008) (Cunningham and Capone, 1990). The VMM has had limited treatment in academic papers. Two papers, Chow et al (1999) and Chow and Liu (2002), discuss the VMM in depth. These two papers mainly concern the value of the VMMs adjustable maturity and are limited to a Hong Kong experience. In Chow et al (1999) they find that the VMM is a less expensive way to borrow as it allows a household to

IS A VARIABLE MARTURITY MORTAGE SAFE?

increase or decrease their rate of prepayment conditioned on the interest rate climate. In Chow and Liu (2002) they argue that VMM borrowers have a slower propensity to prepay and thus the VMM can be used to screen for slower prepayment. With limited data and experience regarding the VMM in the US, it therefore becomes important to simulate the behavior of the VMM and its subsequent default risk in a US real estate market. I will borrow a method of simulation from Vandell (Vandell, 1978), wherein he was able to generate estimates of default risk of Alternative Mortgage Instruments (AMI). He did so by transforming Von Furstenbergs (1969) model to specifications for his particular AMI of interest. He then simulated the AMI and FRM default risk under different scenarios and was able to make inferences regarding the relative riskiness of the AMI to the FRM.

III.

Method

The preferred method to test the default risk of the VMM would be to first access a portfolio of ex-post disaggregate FRMs. The FRM is preferred because the VMM could be viewed as a FRM with a variable maturity. This portfolio would preferably include attributes of both the borrower and mortgage terms (including incidence of default). This would make for a better means of controlling for all potential determinants of default risk to the VMM. Private firms, Banks, Mortgage Lenders, and Government Agencies do allow access to large databases but at high costs, both in time and money. Therefore I will use the Vandell method (1978) discussed above. This is an inferior method compared to a portfolio of ex-post mortgages; however, it will generate estimates of default risk at low costs in both time and money.

IS A VARIABLE MARTURITY MORTAGE SAFE?

I would favor using a more advance model of default risk rather than OLS. I would prefer a logit estimation model (Cunningham and Capone,1990). A logit estimation model would correct the un-boundness estimation of the OLS (Studenmund, 2006), for instance historical interest rate paths exist where the OLS model used in this paper would predict default risk in excess of 100 percent, which is inconceivable. An additional technique to model default risk is the proportional hazard estimation model (PHE) (Quercia and Stegman, 1992). In short the PHE is used to show the probability of default at an age conditional on the survival to that age. Quigley and Van Order use this PHE to estimate probability of default at age, origination year, and LTV (Quigley and Van Order, 1991). Thus using the transformation in this paper the PHE could be used to model default probability for the VMM. The Vandell (1978) method of estimating the riskiness of the VMM followed a four step process to re-specify Von Furstenburgs 1969 model, Vandell (1978) described his method below: (1) a range of explanatory variable values were selected for the Von Furstenberg model, which is specified in terms of component loan parameters; (2) these values were used to develop estimates of default risk under the Von Furstenberg model: (3) these same values were transformed to form values for the explanatory variables of the present model; and finally (4) the transformed variables were regressed on the developed estimates of default risk. (p.1284)

To estimate the default risk of the VMM I transformed the age from origination to time to maturity. This was done by subtracting age from origination from the original contract term to

IS A VARIABLE MARTURITY MORTAGE SAFE?

maturity, as a result providing the time to maturity variable; I then regressed time to maturity and initial LTV onto Von Furstenbergs (1969) estimates of default for all homes, therefore providing the effect of variable and maturity and initial equity on default. Household default behavior can be predicted using the, Frictionless Option Model (FOM) (Geradi et al, 2009). This model states that households will exercise their option to default if the value of the mortgage to the lender falls below the house price (Kau et al, 1994). The assumptions of the FOM are implicit in my simulation of default risk. Vandell (1978) proposed the major source of risk for AMIs was the varying rate of equity accumulation. I believe the VMM suffers from the same source of risk. As interest rates rise above the initial interest rate the rate of equity accumulation for the VMM decreases. This is due to the VMMs fixed payment and variable maturity. At high interest rates and high initial LTV the option to default is closer to, being in the money. Therefore, under the FOM, it is appropriate to use initial LTV and time to maturity to model default risk, as they proxy for both initial equity and equity accumulation. Von Furstenbergs (1969) model had the following specification:
Ln(D/E)t= 0 + 1ln(10(1-L/V)) + 0 2lnt + 3t2+ (D/E)t= Defaults over Endorsements at time t L/V=Loan to value t= age of mortgage (p.466)

Like Vandell (1978), I provided a chart below visualizing the transformation.

IS A VARIABLE MARTURITY MORTAGE SAFE?

Von Furstenberg Model ln(D/E)t 0 1ln(10(1-(L/V)) 2lnt 3t2

Transformation T0 - t = M -

VMM Model ln(D/E)t 0 1ln(10(1(L/V)) 2lnM -

M= Time to Maturity T0=Original Contract term to Maturity Thus the new Model is: Ln(D/E)t= 0 + 1ln(10(1-L/V)) + 2lnM +

The method of simulating default risk for the VMM and FRM in Utah involved five steps: 1) choose an origination date and loan parameters (e.g. 30 year original term to maturity, interest rate, LTV). I simulated two different LTVs at each origination time, one at 97 (the limit of FHA approved borrowing, this represents cash constrained poor households), and the other at the average LTV for Utah. The Hancock and Passmore (2009) paper theorized that the interest rate for a VMM would most likely be somewhere between the FRM and ARM. Using this theory, the interest rate is set at the annual average mortgage rate for Utah, and then reset at the subsequent rate each year. 2) Using these historical inputs, an annuity equation was used to model the movement of maturity at the reset date. 3) I then used the new time to maturity at the reset date and the initial LTV in the VMM model, to estimate default risk at the reset date. 4) I summed the total default risk over the period, and used this as a measure of cumulative default risk. 5) The percent riskiness of the VMM relative to the FRM over the simulated period is then

IS A VARIABLE MARTURITY MORTAGE SAFE?

derived by subtracting the default risk of the VMM from the FRM and dividing by the FRM default risk. IV. Data Von Furstenbergs (1969) original data source used a table compiled by the FHA (Federal Housing Administration). The mortgages included were FRMs insured by the FHA between 1957 and 1962 with contract terms of 20, 25, and 30 years. The table measured the defaults of these mortgages between 1962 and 1967. Von Furstenberg (1969) enumerated a few concerns he had with the data. First, he stressed that this data had a sampling bias as the sampling ratio was weighted heaver in 1957 and less in 1965. This means that any derived results are more influenced by the experience of mortgages insured in 1957. Additionally, the definition of age used for the table was inexact as the first year was considered between 0 and 23 months. This added some haziness to his estimates of default risk at younger ages. Lastly, the time tracked was short. This could mean that we do not see the full magnitude of default risk at the end of maturity. Furthermore, Von Furstenberg (1969) did/could not include any yearly dummy variables. Together these biases will cast doubt on inferences made from my simulation. I used historical data from the Federal Housing Finance Agency (FHFA) to simulate Utah market conditions (http;//www.FHFA.gov). This included data on an annual basis. The data contained average historical data of the following: mortgage rates, purchase prices, term to maturity, initial LTV.

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Table I Number of obs. F( 2, 4647) Prob > F R-squared Root MSE Robust Std. Err. 0.146043 0.152483 0.417486 4650 1004.55 0.0000 0.5039 6.3479

Ln (D/E) Ln (10*(1-(L/V)) Ln (M) Cons.

Coef. -1.425403 6.659047 -27.80604

t -9.76 43.67 -66.60

P>t 0.000 0.000 0.000

[95% Conf. Interval] -1.711717 6.360108 -28.62451 -1.13909 6.957986 -26.98757

IV.

Results

Using the method outlined above, table 1 exhibits the estimates of my model. I used Stata software to run OLS robustly. The models coefficients have the correct sign and they are all statistically significant. I first simulated the VMM and the FRM risk of default for a mortgage originated on January 1st 1986. This was an era where the average mortgage rate in the state of Utah had little upward movement around the origination and then exhibited continual falling interest rates. Table II exhibits the advantages of the VMM relative to the FRM.

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Table II. Default Risks , LTV = 0.97 vintage 1986

4% 3% 3% 2% Default Risk 2% 1% 1% 0% VMM FRM

Table II. Default Risk as measured by Von Furstenberg is the Default Rate in the FHA table set. The FRM and VMM were originated at LTV of 0.97 and on January 1st 1986.

Year

As shown above the VMM would be paid off at year 19 as opposed to the 30 year FRM; this is due to the periods falling rates which caused the VMMs rate of equity accumulation to increase relative to the FRM. The simulation shows that over this time period, the VMM is 64 percent less risky than the FRM. The VMMs cumulative default risk was 3.85 percent and the FRM cumulative default risk was 10.80 percent, however, if the LTV were at the average level in Utah of 77.5 percent the cumulative default risk drops dramatically. The model then predicts that a VMM originated in 1986 would have a 0.38 percent cumulative risk of default and a FRM originated at the same time would have a 1.06 percent cumulative risk of default.

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Table III. Relative Riskiness ,LTV = 0.97 vintage 1986

0 -0.2 -0.4 Relative Risk -0.6 (VMM-FRM)/FRM -0.8 -1 -1.2 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Year
Table V. Measure of the Relative Riskiness of the VMM to the FRM over time. This is measured by finding the percent difference at given year.

So how would the VMM have performed at the height of the housing bubble and the subsequent crash? The next simulation was originated on January 1, 2004. This era exhibited volatile mortgage rates. There was a slight increase as rates moved upward by 3 percent from 2004 to 2005, and then a dramatic 12 percent rise in rates from 2005 to 2006. Rates remained high for some time and did not fall back to or below origination rates until 2009. These dramatic movements are reflected in the estimated default risk. The VMM is at its height of time to maturity of 41.48 years in 2006 contrary to the 28 years under the FRM. In 2006 a VMM with

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LTV of 97 percent had a 27.7 percent risk of default while the FRM had a 2.02 percent. The cumulative risk of default from 2004 to 2010 would have been 56 percent compared to the FRMs 12.28 percent. At the average LTV, 75.3 percent in 2004, the risk drops substantially; at its height of time to maturity the predicted risk of default for the VMM and FRM would have been 1.37 and 0.01respectively, with a predicted cumulative risk of default of 2.77 and 0.608 percent respectively. The simulation predicts the VMM would have been 3.56 times more risky than the FRM during this period. Table IV. Default Risks , LTV = 0.97 vintage 2004
30% 25% 20% Default Risk 15% 10% 5% 0% 2004 2005 2006 2007 Year 2008 2009 2010

VMM FRM

Table IV. Default Risk as measured by Von Furstenberg is the Default Rate in the FHA table set. The FRM and VMM were originated at LTV of 0.97 and on January 1st 2004.

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Table V. Relative Riskiness , LTV = 0.97 vintage 2004

14 12 10 8 Relative Riskiness of 6 the VMM 4 2 0 2004 -2 2005 2006 2007 Year 2008 2009 2010

(VMM-FRM)/FRM

Table V. Measure of the Relative Riskiness of the VMM to the FRM over time. This is measured by finding the percent difference at given year.

V.

Conclusions

Is a VMM a safe instrument for poor households? The VMM does have some interesting characteristics which in theory make it attractive for poor households. The VMM shares risk between the borrower and the lender through a variable maturity, which should decrease initial costs of borrowing. Additionally, the payment is fixed so that household is shielded from payment shocks. However, one would expect that poor households have a harder time increasing their initial equity with a larger down payment, and the effect of LTV on default in my model dramatically increased or decreased the risk of default in the above simulations. I suspect that this is due to the slow accumulation of equity at high interest rates inherent in the VMM, thus keeping high LTV borrowers close to the negative equity threshold during periods of high

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interest rate and increasing the likelihood of the default option being, in the money. My model did not include house price movements, which is a key determinant of default (surely this affects the validity of my estimates). In the simulation of the 2004 to 2010 period, house prices were very volatile this could have erased the limited equity a poor VMM borrower would have and might make the option to default optimal. Furthermore, there are interest rate paths which would cause the VMMs payment to be less than the required interest hence under these scenarios negative amortization would occur of which both Chow et al (1999) and the Hancock and Passmore (2009) mentioned. The potential for negative amortization, slow equity accumulation, and decreasing house prices only compound the risk of the VMM for poor households. On the contrary the FRM carries a payment shock shield like the VMM but it also has a scheduled rate of equity accumulation, and is immune to negative amortization. Therefore the VMM carries more risks than the FRM, and the FRM should be preferred over the VMM for poor households, whom require high LTV ratios. Refinements I would submit two suggestions for refinements to future research regarding the VMM and its recommendation for poor households I) A stronger conclusion could be drawn with access to better data (i.e. ex post disaggregate FRM database) with more control variables (divorce, house price, year originated, unemployment). More sophisticated techniques or models (logit or proportional hazard estimation) could sharpen the accuracy of simulations of default risk for the VMM.

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II)

If further examinations render the same results as I did concerning the riskiness of the VMM, the question should become: Can the VMM be engineered to reduce its risk? Hancock and Passmore (2009), discussed floors and caps on interest rate movements for the VMM as potential means to decrease risk. Using better data and techniques potential improvements on the VMM could be simulated and tested for default risk.

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References
Capozza, D.R., Kazarian, D., & Thomson, T. (1997). Mortgage Default in Local Markets, Real Estate Economics, 25, 631-651 Chow, Y-F., Huang, C., & Liu, M. (2000). Valuation of Adjustable-Rate Mortgages with Automatic Stretching Maturity, Journal of Banking and Finance, 24, 1809-1829 Chow, Y-F, Liu, M. (2003). The Value of the Variable Tenor Mortgage Feature in China, Pacific-Basin Finance Journal, 11, 61-80 Cunningham, D. F., Capone, C.C., Jr. (1990). The Relative Termination Experience of Adjustable to Fixed-Rate Mortgages, The Journal of Finance, 49, 1687-1703 Demyanyk, Y., Koijen, R.S.J., & Van Hemert,O.A.C. (2011). Determinants and Consequences of Mortgage Default, Working Paper. Deng, Y., Quigley,J.M., & Van Order,R., (2000). Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options, Econometrica, 68, 275-307 Federal Housing Finance Agency. (n.d.). Annual by State. Retrieved from http://www.fhfa.gov/Default.aspx?Page=252 Foote, C. L., Gerardi,K., & Willen,P.S. (2008). Negative Equity and Foreclosure: Theory and Evidence, Journal of Urban Economics, 64, 234-245 Geradi, K., Shapiro,A.H, & Willen,P.S. (2009). Subprime Outcomes: Risky Mortgages, Homeownership Experiences, and Foreclosures, Federal Reserve of Boston Working Paper No 07-15 Hancock, D.,Passmore,W. (2009). Three Inititatives Enhancing the Mortgage Market and Promoting Financial Stability, The B.E. Journal of Economic Analysis & Policy, 9 (Symposium), 1-23, Article 16 Kau, J. B.,Keenen,D.C.,& Kim,T., (1994). Default Probabilities for Mortgages, Journal of Urban Economics, 35, 278-296 Pennington-Cross, A., Ho,G. (2010). The Termination of Subprime Hybrid and Fixed Rate Mortgages, Real Estate Economics, 38,399-426 Quercia, R., Stegman, M. A. (1992). Residential Mortgage Default: A Review of the Literature, Journal of Housing Research, 3, 341-79

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Quigley, J.M, Van Order, R. (1991). Defaults on Mortgage Obligations and Capital Requirements for U.S. Savings Institiutions: A Policy Perspective, Journal of Public Economics, 44, 353-370 Studenmund, A.H. (2006). Using Econometrics a Practical Guide. New York: Pearson Addison Wesley. Vandell, K. (1978). Default Risk Under Alternative Mortgage Instruments, The Journal of Finance, 33, 1279-1296 Von Furstenberg, G. M. (1969). Default Risk on FHA-Insured Home Mortgages as a Function of the Terms of Financing: a Quantitative Analysis, The Journal of Finance, 24, 459-477 Von Furstenberg, G.M. (1970a). Interstate Differences in Mortgage Lending Risks: An Analysis of Causes, Journal of Financial and Quantitative Analysis, 5, 229-242 Von Furstenberg, G.M. (1970b). The Investment Quality of Home Mortgages, Journal of Risk and Insurance, 37, 437-445 Von Furstenberg, G.M., Green, R.J. (1974). Estimation of Delinquency Risk for Home Mortgage Portfolios, Real Estate Economics, 2, 5-14