The Dynamics of Adjustable-Rate Subprime Mortgage Default: A Structural Estimation∗

One important characteristic of the recent mortgage crisis is the prevalence of subprime mortgages with adjustable interest rates and their high default rates. In this paper, we build and estimate a dynamic structural model of adjustable-rate mortgage defaults using unique mortgage loan level data. The data contain detailed information not only on borrowers’ mortgage payment history and lender responses but also on their broad balance sheet. Our structural estimation suggests that the factors that drive the borrower delinquency and foreclosure differ substantially by the year of loans’ origination. For loans that originated in 2004 and 2005, which precedes the severe downturn of the housing and labor market conditions, the interest rate resets associated with ARMs, as well as the housing and labor market conditions do not seem to be important factors for borrowers’ delinquency behavior, though they are important factors that determine whether the borrowers would pay off their loans (i.e., sell their houses or refinance). However, for loans that originated in 2006, interest rate reset, housing price declines and worsening labor market conditions all contributed importantly to their high delinquency rates. Countefactual policy simulations also suggest that monetary policies in the most optimistic scenario might have limited effectiveness in reducing the delinquency rates of 2004 and 2005 loans, but could be much more effective for 2006 loans. Interestingly, we found that automatic modification loans in which the monthly payment and principal balance of the loans are automatically reduced when housing prices decline can reduce delinquency and foreclosure rates, and significantly so for 2006 loans, without having much a negative impact on lenders’ expected income. ∗Preliminary and Incomplete. All comments are welcome. The views expressed are those of the authors and do not necessarily reflect those of the Board of Governors of the Federal Reserve, the Federal Reserve Bank of Philadelphia, or the Federal Reserve System. †Department of Economics, University of Pennsylvania, 3718 Locust Walk, Philadelphia, PA 19104 and the NBER. Email: [email protected] ‡Division of Research and Statistics, Board of Governors of the Federal Reserve System. Email: [email protected]. §Department of Research, Federal Reserve Bank of Philadelphia. Email: [email protected].