An examination of 2/28 hybrid mortgage foreclosures

This paper extends research on the U.S. mortgage crisis by examining the causal links between payment shocks associated with subprime adjustable rate mortgages (ARMs), subprime ARM foreclosure rates, and house price appreciation rates. The study focuses on 2/28 hybrid mortgages which represent the majority of subprime originations. This mortgage instrument has a 2-year period of fixed interest rates followed by a 28-year period of adjustable interest rates. During the latter period, interest rates reset every six months to a rate equal to the 6-month London Interbank Offered Rate (LIBOR) plus a margin. Since foreclosure rates and house price appreciation rates are simultaneously determined, a system of equations modeling approach is used to examine quarterly data for aggregate foreclosure rates and house price appreciation rates during the period 2000 through 2009. The findings show that lagged payment shocks at the initial interest rate reset significantly increase subprime ARM foreclosure rates and have no impact on the foreclosure rates of other mortgage instruments. Also, increases in lagged subprime ARM foreclosure rates significantly decrease house price appreciation rates. In addition, foreclosure rates for prime ARMs and prime fixed rate mortgages (FRMs) significantly increase as house price appreciation rates decrease. These findings, taken together, suggest that payment shocks associated with 2/28 hybrid mortgages contributed to the US mortgage crisis by increasing subprime ARM foreclosures, which led to significant house price declines. This triggered increases in foreclosure rates for prime ARMs and prime fixed rate mortgages (FRMs). Equally important, foreclosure rates for subprime FRMs surged as U.S. unemployment rates increased. While several studies conclude that payment shocks associated with subprime ARMs did not trigger the wave of subprime foreclosures that occurred during the U.S. mortgage crisis, these studies generally model mortgage default rates using loan-level data and treat house prices as an exogenous variable. This approach does not account for endogeneity. This difference in findings leads to important distinctions regarding policy recommendations for lenders related to contract design and risk mitigation. Foremost, this study highlights the importance of designing mortgage contracts that diminish payment shocks. In addition, risk mitigation techniques, such as loan modifications and workouts, need to promote affordable payment terms.