Tag Archives: loan contract

The Miraculous Continuous Workout Mortgage

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Professor Robert Shiller

Nobel Prize winner Robert Shiller et al. have posted Continuous Workout Mortgages: Efficient Pricing and Systemic Implications to SSRN. The paper opens,

The ad hoc measures taken to resolve the subprime crisis involved expending financial resources to bail out banks without addressing the wave of foreclosures. These short-term amendments negate parts of mortgage contracts and question the disciplining mechanism of finance. Moreover, the increase in volatility of house prices in recent years exacerbated the crisis. In contrast to ad hoc approaches, we propose a mortgage contract, the Continuous Workout Mortgage (CWM), which is robust to downturns. We demonstrate how CWMs can be offered to homeowners as an ex ante solution to non-anticipated real estate price declines.

The Continuous Workout Mortgage (CWM, Shiller (2008b)) is a two-in-one product: a fixed rate home loan coupled with negative equity insurance. More importantly its payments are linked to home prices and adjusted downward when necessary to prevent negative equity. CWMs eliminate the expensive workout of defaulting on a plain vanilla mortgage. This subsequently reduces the risk exposure of financial institutions and thus the government to bailouts. CWMs share the price risk of a home with the lender and thus provide automatic adjustments for changes in home prices. This feature eliminates the rational incentive to exercise the costly option to default which is embedded in the loan contract. Despite sharing the underlying risk, the lender continues to receive an uninterrupted stream of monthly payments. Moreover, this can occur without multiple and costly negotiations. (1, references omitted)

If it is not obvious, this is a radical idea.  It was not even contemplated before the financial crisis. That being said, it is pretty brilliant financial innovation, one that should not just be discussed by academics. The paper provides a lot more detail about the proposal for those who are interested. And if you want to avoid taxpayer bailouts of the housing market in the future, you should be interested.

What Do People Do When Mortgage Payments Drop?

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I went to an interesting presentation today on a technical paper, Monetary Policy Pass-Through: Household Consumption and Voluntary Deleveraging. While the paper (by Marco Di Maggio, Amir Kermani & Rodney Ramcharan) itself is tough for the non-expert, it has some important implications that I discuss below. The abstract reads,

Do households benefit from expansionary monetary policy? We investigate how indebted households’ consumption and saving decisions are affected by anticipated changes in monthly interest payments. We focus on borrowers with adjustable rate mortgages originated between 2005 and 2007 featuring an automatic reset of the interest rate after five years. The monthly payment due from the average borrower falls by 52 percent ($900) upon reset, resulting in an increase in disposable income totaling tens of thousands of dollars over the remaining life of the mortgage. We uncover three patterns. First, the average household increases monthly car purchases by 40 percent ($150) upon reset. Second, this expansionary effect is attenuated by the borrowers’ voluntary deleveraging, as a significant fraction of the increased income is deployed to accelerate debt repayment. Third, the marginal propensity to consume is significantly higher for low income and underwater borrowers. To complement these household-level findings, we employ county-level data to provide evidence that consumption responded more to a reduction in short-term interest rates in counties with a larger fraction of adjustable rate mortgage debt. Our results shed light on the income channel of monetary policy as well as the role of debt rigidity in reducing the effectiveness of monetary policy. (1)

The paper cleverly exploits

the anticipated changes in monthly payments of borrowers with adjustable rate mortgages (ARMs) originated between 2005 and 2007, with a fixed interest rate for the first 5 years, which is automatically adjusted at the end of this initial period. These cohorts experience a sudden and substantial drop in the interest rates they pay upon reset, regardless of their financial position or credit worthiness and without refinancing. These cohorts are of particular interest because the interest rate reduction they experienced is sizeable: the ARMs originated in 2005 benefited from an average reduction of 3 percentage points in the reference interest rate in 2010. (3)

I will leave it to individual readers to work through how they designed this research project and move on to its implications:

The magnitude of the positive income shock for these households is large indeed: the monthly payment falls on average by $900 at the moment of the interest rate adjustment. Potentially, this could free up important resources for these indebted and mainly underwater households. We show that households increase their car purchase spending by more than $150 per month, equivalent to a 40 percent increase compared to the period immediately before the adjustment. Their monthly credit card balances also increase substantially, by almost $200 a month within the first year after the adjustment. Moreover, there is not any sign of intertemporal substitution or reversal within two years of the adjustment. . . . However, we also show that households use 15% of their increase in income to repay their debts faster, almost doubling the extent of this effort. (38-39)

There are all sorts of interesting implications that follow from this study, but I am particularly intrigued by its implications for “debt rigidity — the responsiveness of loan contracts to interest rate changes.” (6) While the authors are interested in how debt rigidity can impact monetary policy, I am interested in how it can impact households. There is much in the American housing finance system that keeps households from refinancing — high title insurance charges and other fees, for instance — but we do not often focus on the impact that rigid mortgage contracts have on the broader economy. This paper demonstrates that the effects are not borne by consumers alone. This paper quantifies the effects on the consumer economy to some extent and reveals that they are quite significant. Policy makers should take note of just how significant they can be.