Credit, equity, and mortgage refinancings 2

Recognition that individual loan, property, and borrower characteristics, in addition to changes in interest rates, play a key role in determining the likelihood of a mortgage prepayment has spawned a relatively new branch of research based on loan-level data sets. This research has generally focused on the three major underwriting criteria that mortgage lenders consider when deciding whether to extend credit: equity (collateral), income, and credit history.

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However, past studies have only investigated the effects of changes in homeowners' equity and income on their ability to prepay. For example, Cunningham and Capone (1990)-using a sample of loans secured by properties in the Houston, Texas, area--estimated post-origination loan-to-value (LTV) ratios and post-origination payment-to-income ratios based on changes in regional home prices and incomes.

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(2) They concluded that post-origination equity was a key determinant of the termination experience of those loans (they found an inverse relationship for defaults and a positive relationship for refinancings and home sales), whereas post-origination income was insignificant. Caplin, Freeman, and Tracy (1993), using a sample of loans secured by properties in six states, also found evidence of the importance of home equity in influencing the likelihood of mortgage prepayment.

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They assessed the effect of post-origination equity by dividing their sample into states with stable or weak property markets (using transaction-based home price indexes for specific metropolitan statistical areas) and according to whether the loans had high or low original LTV ratios. Consistent with the hypothesis that changes in home equity play an important role in prepayments, the authors found that in states with weak property markets, prepayment activity was less responsive to declines in mortgage interest rates than in states with stable property markets.

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In a related study, Archer, Ling, and McGill (1995) found that home equity had an important effect on the probability that a loan would be refinanced, and provided evidence that changes in borrower income are also a significant factor. The authors matched records from the 1985 and 1987 national samples of the American Housing Survey to derive a subsample of nonmoving owner-occupant households with fixed-rate primary mortgages, some of whom had refinanced, since the interest rate on their loan in 1987 was different from that reported in 1985. The authors' estimate of post-origination home equity was derived from the sum of the book value of a homeowner's entire mortgage debt, including second mortgages and home equity loans, divided by the owner's assessment of the current value of his or her property.

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(3) In addition, a post-origination mortgage payment-to-income ratio, derived from the homeowner's recollection of total household income, was included as an explanatory variable. The authors found that, along with changes in interest rates, post-origination home equity and income were significant and of the expected sign.
This article goes beyond the existing literature in several important respects. Ours is the first study to investigate systematically the effect of the third underwriting criterion: homeowners' credit histories. Ours is also the first study to estimate post-origination equity by using county-level repeat sales home price indexes.

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(4) These indexes are generally regarded as the best available indicator of movements in home prices over time. In addition, we employ a unique loan-level data set that not only provides information on credit history but also identifies the reason for prepayment: refinance, sale, or default (see box). The size of the data set allows very large samples to be drawn for major population centers as well as for the nation as a whole.

Credit, equity, and mortgage refinancings

Homeowners typically have the option to prepay all or part of the outstanding balance of their mortgage loan at any time, usually without penalty. However, unless homeowners have sufficient wealth to pay off the balance, they must obtain a new loan in order to exercise this option. Studies examining refinancing behavior are finding more and more evidence that differences in homeowners' ability to qualify for new mortgage credit, as well as differences in the cost of that credit, account for a significant part of the observed variation in that behavior.

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Therefore, individual homeowner and property characteristics, such as personal credit ratings and changes in home equity, must be considered systematically, along with changes in mortgage interest rates, in the analysis and prediction of mortgage prepayments.

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Early research into the factors influencing prepayments focused almost exclusively on the difference between the interest rate on a homeowner's existing mortgage and the rates available on new loans. This approach arose in part because researchers most often had to rely on aggregate data on the pools of mortgages serving as the underlying collateral for mortgage-backed securities (for example, see Schorin {1992}). More recent research, however, has broadened the scope of this investigation through the utilization of loan-level data sets that include individual property, loan, and borrower characteristics.

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This article significantly advances the literature on mortgage prepayments by introducing quantitative measures of individual homeowner credit histories to the loan-level analysis of the factors influencing the probability that a homeowner will refinance. In addition to credit histories, we include in the analysis changes in individual homeowner's equity and in the overall lending environment. Our findings strongly support the hypothesis that, other things being equal, the worse a homeowner's credit rating, the lower the probability that he or she will refinance. We also confirm the finding of other researchers that changes in home equity strongly influence the probability of refinancing. Finally, we provide evidence of a change in the lending environment that, all else being equal, has increased the probability that a homeowner will refinance.

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These findings are important from an investment risk management perspective because they confirm that the responsiveness of mortgage cash flows to changes in interest rates will also be significantly influenced by the credit and equity conditions of individual borrowers. Moreover, evidence overwhelmingly indicates that these conditions are subject to dramatic changes. For example, although the sharp rise in personal bankruptcies since the mid-1980s (Chart 1) partly reflects changes in laws and attitudes, it nonetheless suggests that credit histories for a growing segment of the population are deteriorating. Furthermore, home price movements, the key determinant of changes in homeowners' equity, have differed considerably over time and in various regions of the country. Indeed, in the early to mid-1990s home price appreciation for the United States as a whole slowed dramatically while home prices actually fell for sustained periods in a few regions (Chart 2).

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In short, as mortgage rates fell during the first half of the 1990s, many households likely found it difficult, if not impossible, to refinance existing mortgages because of poor credit ratings or erosion of home equity.(1) Consequently, the prepayment experience of otherwise similar pools of mortgage loans may vary greatly depending on the pools' proportions of credit- and/or equity-constrained borrowers.

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Our findings also contribute to an understanding of how constraints on credit availability affect the transmission of monetary policy to the economy (for example, see Bernanke {1993}). Fazzari, Hubbard, and Petersen (1988) and others have found that investment expenditures by credit-constrained businesses are especially closely tied to those firms' cash flows and are relatively insensitive to changes in interest rates, reflecting constraints on their ability to obtain credit.

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Analogously, we find credit- and/or equity-constrained homeowners to be less sensitive to changes in interest rates because of their limited access to new credit, thereby short-circuiting one channel through which lower interest rates improve household cash flows and stimulate the economy.