Credit risk, credit scoring, and the performance of home mortgages - includes related information

Federal Reserve Bulletin, July, 1996 by Robert B. Avery, Raphael W. Bostic, Paul S. Calem, Glenn B. Canner

Because default is costly, the interest rates lenders charge incorporate a risk premium. To the extent that the causes of default are not well understood, lenders may charge a higher average price for mortgage credit to reflect this uncertainty. Alternatively, lenders may respond to this uncertainty by restricting credit to only the most creditworthy borrowers. By better distinguishing between applicants that are likely to perform well on their loans from those that are less likely to do so, lenders can ensure wider availability of mortgages to borrowers at prices that better reflect underlying risks.

Default also imposes great costs both on the borrowers involved in the process and on society in general. For borrowers, default ordinarily results in a lower credit rating and reduced access to credit in the future, a loss of assets, and the costs of finding and moving to a new home. When geographically concentrated, defaults can also have a pronounced social effect because they lower local property values, reduce the incentives to invest in and maintain the homes in the affected neighborhoods, increase the risk of lending in those neighborhoods, and thus reduce the availability of credit there.

Theoretical and Empirical Determinants

of Credit Risk

Gaining a greater understanding of the factors that determine mortgage loan delinquency and default has been an objective of mortgage lenders, policy makers, and academics for decades. A better understanding of these relationships holds the promise that lenders can more accurately gauge the credit risk posed by different applicants and increase the safety and profitability of mortgage lending.

An extensive literature regarding the theoretical and empirical determinants of mortgage credit risk has developed over the past three decades.(3) This literature emphasizes the important roles of equity in the home and vulnerability to so-called triggering events in determining the incidence of delinquency and default. These studies have enhanced our understanding of the determinants of credit risk and have established a better foundation for consistent and effective mortgage lending.

Theoretical Determinants

of Mortgage Loan Performance

Most models of mortgage loan performance emphasize the role of the borrower's equity in the home in the decision to default. So long as the market value of the home (after accounting for sales expenses and related costs) exceeds the market value of the mortgage, the borrower has a financial incentive to sell the property to extract the equity rather than default.(4) "Option-based" theories provide a framework for understanding the relationship between equity and loan performance; these theories view the amount of equity accumulated in the property as the key determinant of whether a borrower will default. Within this framework, mortgage default is viewed as a put option, in which the borrower has the right (option) to transfer ownership of (put) the home to the lender (through foreclosure or voluntarily) to retire the outstanding balance on the loan. Borrowers will be increasingly likely to exercise this option the further the market value of the house falls below the value of the mortgage. However, because of high transaction and other costs (for example, moving expenses and damage to the borrower's credit rating resulting from default), few borrowers would be expected to exercise this option "ruthlessly" (that is, default as soon as equity falls below zero).(5)