Concern about foreclosures has been heightened recently by the increase in subprime loans and the rise in the number of foreclosures. While there are numerous studies of foreclosure, one area that needs more consideration is the process that occurs after a borrower defaults and before a loan is eventually either restored to good standing (“cured”) or ends in foreclosure. In a recent study, Dennis Capozza and Thomas Thomson examine this process for a sample of subprime mortgages and identify the important predictors of a loan’s transition from default to its final state of being cured or foreclosed. What follows is a summary of their findings.1
Lenders are well aware that some mortgage loans might default. Thus, they must exercise due diligence when deciding which mortgage applications to approve. Several studies have aided lenders in their decision-making process by highlighting the determinants of default. However, these studies generally define default as “the completion of the foreclosure process and sale of the collateral.” While these studies are helpful, they fail to shed light on the period of transition, which can be quite complicated and involve many steps, before the loan results in foreclosure or is cured. An understanding of the process from a loan’s delinquent status to cure or foreclosure can be especially instructive given the rise in subprime lending and the mounting evidence that the behavior of subprime borrowers differs from that of prime borrowers. Capozza and Thomson cite research that indicates “subprime mortgage loans default earlier than prime loans and the losses are larger than for prime loans.”
Since subprime borrowers tend by definition to have less than perfect credit, lenders charge a higher interest rate to compensate for the greater risk associated with the loan. Because of the interest rate premium, 2 a payment from a subprime borrower contributes more to net revenue than one made by a prime borrower. Therefore, the prospect of potential net revenue from an active loan account might affect a lender’s or investor’s treatment of a borrower with delinquent payments. In fact, the authors point out that “given the high delinquency rates reported for subprime mortgage pools, relative to the number of foreclosures, forbearance and extension rather than immediate foreclosure are common reactions to missed payments.”
The authors consider two explanations. First, they “hypothesize that loans will transition less quickly to foreclosure and REO3 when one more payment is more valuable to the lender because the interest rate premium is higher.” Second, they “conjecture that foreclosure will be delayed when measures of borrower creditworthiness, such as bureau scores, payment to income ratios, time on the job, etc. are weaker.” The authors test these hypotheses using a unique sample of subprime mortgages.
Capozza and Thomson tracked a sample of 6,181 mortgage loans originated by a national subprime lender. The loans were in default (90 days or more delinquent) on September 30, 2001. The data used in the analysis contained information on the loan, the borrower, and the type of property. 4 The authors studied the transition of the loans to their status eight months later. The possible outcomes at the later date were: (1) the loan remains delinquent without further deterioration, (2) the loan is in foreclosure or becomes REO, (3) the loan becomes more delinquent, i.e., worsens, (4) the borrower is in bankruptcy, or (5) the loan is cured.
First, the authors focused on the overall transition outcomes and then modeled the transition of the loans to one of the states above using regression analysis.5
The authors divided the sample of defaulted loans into two groups according to whether, on September 30, 2001, borrowers were not in bankruptcy (4,243 loans) or were in bankruptcy (1,938 loans) and noted the status of the loans eight months later. They found that 59 percent of the 4,243 defaulted loans were still in default status; 24 percent became REO; for 11 percent the borrower entered bankruptcy; and 6 percent were cured. After the eight-month period for those loans with a borrower initially in bankruptcy, 69 percent remained with a borrower in bankruptcy, 18 percent were in default but the borrower was not in bankruptcy, 12 percent went to REO, and 2 percent were cured. This, the authors suggest, indicates that defaulted loans with the borrowers not in bankruptcy and those in default and the borrowers originally in bankruptcy tend to remain in their respective status for an extended period.
The authors regarded the percentages as constant transition rates and used them to project the rate at which loans either reach REO or are cured. Using these transition rates, there would be a total of 2,159 loans in REO after the second round.6 After numerous rounds, they found that 79 percent of the sample loans would reach REO, while 21 percent would ultimately be cured; it would take “about six and one half years for 90% of the transitions to the final states to occur and confirms that subprime loans linger in a delinquent state for extended periods of time.” The authors also noted that the transition results of their loan sample to REO differed from those reported in the literature for conventional or FHA loans. Their subprime sample was “about twice as likely to transition to REO but [took] about four times longer to get there.”
For a more in-depth investigation of the transition process, Capozza and Thomson used regression analysis to examine the determinants of a loan’s transition from default to one of the other possible states mentioned above. Concentrating on the loans initially in default but the borrowers not in bankruptcy, they found the following:
The analysis of the loans originally in default and the borrowers in bankruptcy revealed:
In general, the authors observed that the “most economically important predictors of transition from default to any other state are the number of payments the borrower has made and the loan-to-value ratio.”