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Update Newsletter: Special Edition 2011

Five Easy Pieces: Recent Examples of Research on Consumer Credit at the Philadelphia Fed

The Payment Cards Center is just one of many areas at the Philadelphia Fed studying consumer credit markets. In this edition of the newsletter, we showcase a few of the recent studies produced by staff in other parts of the Bank.*

Our first example is a paper co-authored by Wenli Li of the Research Department (with Michelle White of the University of California, San Diego, and Ning Zhu of the University of California, Davis). In “Did Bankruptcy Reform Cause Mortgage Default Rates to Rise?,” PDF (241 KB, 30 pages) the authors examine the possibility that recent changes in U.S. bankruptcy law contributed to the subsequent rise in mortgage defaults. How might this happen? The law had two effects. First, it raised the cost of filing for bankruptcy. Second, for some consumers, it reduced the amount of unsecured debt that can be discharged. Both have the effect of reducing the cash flow available to the consumer to pay an outstanding mortgage. Overall, the authors calculate that bankruptcy reform caused the number of mortgage defaults to increase by around 200,000 a year even before the start of the financial crisis, suggesting that the reform increased the severity of the crisis when it came.

Marvin M. Smith, a community development research advisor in the Bank’s Community Development Studies and Education Department, is the co-author of the second paper (with Christy Hevener, formerly of the same department). In “Subprime Lending over Time: The Role of Race,” PDF (971 KB, 26 pages) the authors use a special estimation technique and find that over the period 1999 through 2007, even after taking into account a variety of factors used to underwrite mortgages, the prevalence of subprime mortgages varies by the ethnicity of the borrower.

The final three papers we are featuring in this edition were co-authored by staff in our Bank’s Supervision, Regulation and Credit Department. The first paper was produced by the Philadelphia Fed’s Chris Henderson (with Paul Calem of the Board of Governors and Jonathan Liles of Freddie Mac). In “‘Cream Skimming’ in Subprime Mortgage Securitizations: Which Subprime Mortgage Loans Were Sold by Depository Institutions Prior to the Crisis of 2007?,” PDF (531 KB, 51 pages) the authors investigate the possibility that lenders may be more likely to securitize subprime mortgages that, according to data available only to the loan originator, are riskier than other loans. For a pool of subprime mortgage loans originated in 2005 and 2006, they find evidence consistent with this view.

In another paper, Chris Henderson and Julapa Jagtiani, also of the Supervision, Regulation & Credit Department, examine the relationship between banks’ mortgage portfolios and capital requirements as determined by bank supervisors. In “Can Banks Circumvent Minimum Capital Requirements? The Case of Mortgage Portfolios under Basel II,” PDF (447 KB, 39 pages) the authors show that capital models for mortgages that use different segmentation approaches can produce different amounts of required capital. Because banks typically enjoy some flexibility in how they segment their portfolios, banks may be faced with incentives to choose an approach that results in the least required capital for them. The authors conclude that such incentives should be addressed via supervisory review of banks’ models and segmentation strategy.

In another paper by Julapa Jagtiani, this one coauthored with William Lang (also of our Supervision, Regulation & Credit Department), the authors examine borrowers’ incentives to default on one or both mortgages as home prices have fallen. In “Strategic Default on First and Second Lien Mortgages During the Financial Crisis,” PDF (808 KB, 33 pages) the authors find, somewhat surprisingly, that there are many instances in which consumers default on their first mortgages (the senior loan on a residential property) but continue to pay on their second mortgages (the junior lien). They find that borrowers are more likely to remain current on their second lien if it is a home equity line of credit (HELOC) compared with a closed-end home equity loan. Moreover, the size of the unused line of credit is an important factor. They also find some evidence that mortgage loss mitigation programs may create an incentive for some homeowners to default on their first mortgages.