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

Option-based theories of loan performance identify a number of equity-related factors likely to influence default rates. Included among these are the initial loan-to-value ratio (the ratio of the loan amount to the value of the property), which determines the amount of equity at the time of loan origination; current and expected future rates of home price appreciation, which determine the direction, speed, and size of changes in equity levels; the age of the loan, because equity accumulates as payments on a mortgage reduce the amount owed; and the term of the mortgage, because loans of shorter duration are amortized more quickly. In addition, current mortgage interest rates (relative to the rate on an outstanding loan) influence the likelihood of default by affecting the value of the mortgage to a borrower. For example, a mortgage interest rate below current market levels is a disincentive for the borrower to default because a new mortgage would carry a higher rate.

While option-based theories emphasize the role of equity in the home in determining loan performance, other theories of loan performance additionally emphasize the financial footing of borrowers and their corresponding vulnerability to significant adverse changes in their financial or personal circumstances, referred to as "triggering events." In this view, both negative equity and a triggering event would be associated with most defaults. A triggering event alone would not ordinarily cause a default when a borrower has equity in a home; rather, the borrower would sell the property and fully repay the loan to keep the equity (net of transactions costs) and avoid the adverse consequences of a default. On the other hand, in the absence of a triggering event, a borrower would not be expected to exercise the default option ruthlessly because of the large (transaction and reputation) costs the borrower would bear. A default, in this latter case, would occur only if, in the owner's view, the property's value had declined significantly and prospects for its near-term recovery were poor.

Analysts who emphasize the role of triggering events focus on adversities such as reductions in income brought about by a period of unemployment. Other events that may lead to repayment problems include bouts of illness, which may result in both large expenses and a disruption in income, and changes in family circumstances, particularly divorce. Measures of the borrower's vulnerability to such events include ratios of monthly debt payment to income; the level of financial reserves available to the borrower; measures of earnings stability, such as the borrower's employment history; and the borrower's credit history, which in part reflects the borrower's ability and willingness to manage debt payments in the face of changing circumstances.

Option-based and triggering-event theories suggest different relationships between delinquency and default. In the options-based view, delinquency occurs only as a precursor to default and would be evident only among borrowers with substantial negative equity. Triggering-event theories view delinquencies as related to an event and not necessarily to the borrower's level of equity. In this view, delinquencies are not explicitly linked to default but can lead to default if the triggering event is sufficiently severe and the borrower has substantial negative equity in the home.