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Research Seminars & Workshops @ IRES


Professor Anthony B. Sanders
Distinguished Professor of Real Estate Finance
Center for Real Estate Entrepreneurship, George Mason University

Thy Neighbor's Mortgage:
Does Living in a Subprime Neighborhood Impact Your Probability of Default?


Date:

14 Sep 2009 (Mon)

Time:

2.30 pm - 5.30 pm

Venue:

RMI Seminar Room
21 Heng Mui Keng Terrace, Level 4


Abstract

During the current decade, the U.S. housing market experienced two interrelated events. First, the U.S. experienced a housing market bubble in the early 2000's that started to decline in 2006 and burst in the latter half of 2007.1 Second, during this same period, the use of alternative (or hybrid) mortgage products escalated.2 These products were designed to help borrowers in markets experiencing significant price appreciation. However, they were often marketed to borrowers with relatively poor credit histories as well. As a result, these mortgages became known as subprime mortgages since they did not meet the underwriting criteria of the housing government sponsored enterprises (GSEs).

Since these mortgages were designed to provide borrowers with payment affordability during a period of rapidly rising housing values, the most common subprime mortgages had adjustable rate features and many had provisions for negative amortization of principle thus providing borrowers with low initial payments. The general belief was that rapidly rising home values would allow borrowers to refinance prior to the impact of the negative amortization feature. Of course, many did not foresee the softening of the U.S. housing market eliminating the ability to refinance. Thus, the default rate on subprime mortgages has increased dramatically and current estimates indicate that rising subprime defaults may add over 500,000 homes to the housing supply.3

One interesting feature of these alternative mortgage designs, particularly subprime mortgages, is that they tend to be clustered in metropolitan areas that experienced significant house price increases. For example, Maricopa County (Phoenix, Scottsdale, Mesa and surrounding communities) had one of the most explosive rates in housing prices during the 2004-2006 time period (see Figure 1) with the Case Shiller house price index growing from an index value of 100.00 for January 2000 to a peak of 227.42 in June 2006, indicating that house prices over doubled in price. Hence, Maricopa County represents an excellent laboratory for studying the relationship between house price growth and the mortgage products used to finance home purchases.

To demonstrate the extent of subprime concentration, Figures 2 and 3 show the total mortgage origination activity and subprime origination activity for the Phoenix metropolitan area by zip code between 2000 and 2007. The figures clearly indicate a spatial pattern of mortgage activity. However, to gain a better perspective on subprime clustering, Figure 4 shows the concentration of subprime mortgages by zip code. Not surprisingly, the highest concentration of subprime activity (as a percent of all loan originations) occurs in the urban inner city as opposed to the urban-rural periphery. In fact, between 2004 and 2006, the areas with the highest volume of subprime loan origination were in new build locations (Southeast, West and North) but as a percentage of all loans, the lower-income neighborhoods of Phoenix (downtown, older homes along the interstates going West and North from the downtown) had the highest concentration of subprime activity. Interestingly, interest-only (IO) ARMs are located in the highest price areas of Maricopa County (Scottsdale, Paradise Valley and Ahwatukee), but far less than in the high subprime concentration zip codes.

If subprime lending is correlated with poor underwriting standards, then the clustering of subprime mortgages may cause a spillover effect in terms of default. A number of studies have documented that the most common outcome of default (foreclosure) is a negative spillover onto the value of surrounding properties and neighborhoods.4 For example, Lin, Rosenblatt, and Yao (2008) document that a foreclosure depresses property prices in the surrounding neighborhood by up to 8.7 percent.

But do the spillover effects from subprime defaults imply that subprime borrowers in neighborhoods (or zip codes) that are clustered together have a higher probability of default? That is, once we control for loan characteristics, house price changes and alternative loan products, do subprime borrowers in neighborhoods with higher concentrations of subprime borrowers have a greater likelihood of default? That is the question that we wish to explore in this paper.

Our paper is organized as follows. Section 2 develops a theoretical setup to demonstrate the default cascade resulting from subprime origination in a neighborhood. Section 3 describes the empirical method and section 4 discusses the data. Section 5 describes the results of our empirical analysis and section 6 concludes.

For full paper, download herehttp://www.rst.nus.edu.sg/research/images/pdf1.GIF

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