Adjustable Balance Mortgages: Shared Risk Reduces Strategic Defaults

Two university researchers are proposing a new type of mortgage which they contend would reduce the economic incentive to default on loan obligations while not increasing the cost to either the lender or the borrower.  The concept of an "adjustable balance mortgage" is presented in a forthcoming article in Real Estate Economics by Brent Ambrose, Smeal Professor of Real Estate and director of the Institute for Real Estate Studies at the Penn State Smeal College of Business, and Richard Buttimer, a professor in the Belk College of Business at the University of North Carolina at Charlotte.

Historically, the study says, mortgage default was assumed to result from either a moral failure or cash flow problems that prevented the borrower from repaying his debt.  More recent theory is that the preponderance of defaults results from the value of the home declining to less than the principal balance of the mortgage.  As neither cause could be hedged, foreclosure laws have arisen as the form of contract enforcement.

Economic theory shows that all mortgages have two sources of uncertainty; interest rates and house prices.  The mortgage contract explicitly addresses interest rate risks and addresses them through mechanisms such as fixed versus adjustable rates.  House price risk is not similarly addressed preventively so defaults must be litigated rather than resolved contractually which is costly for both parties.  The lender has to absorb the costs of foreclosure and of maintaining and reselling the collateral while the borrower pays through the loss of his home and elevated future borrowing costs. The current housing crisis demonstrated both the deadweight costs of foreclosing and the insufficiency of the threat of foreclosure to prevent widespread default when home prices fall.  The authors say that this calls for a new type of mortgage that will reduce the risks associated with volatile housing markets.

By reducing the role of the legal system, the adjustable balance mortgage (ABM) captures the risk of house price declines to minimize default risk from declining asset value while still retaining contract rates near the cost of standard mortgages.

At origination the ABM looks like a conventional mortgage, with a fixed rate, maturity term and is fully amortizing.  However, at fixed, pre-set intervals, the lender and the borrower determine the value of the house.  If the house value is lower than the originally scheduled balance at that point in time, the balance is set equal to the house value and the monthly payment is recalculated accordingly.  If the house retains its initial value or increases in value, the loan balance and terms remain unchanged.  If the area index rises after one or more adjustments down then the mortgage could be adjusted upward as high as the originally scheduled  balance at that point in time, but no higher.

By the time the first adjustment occurs, the borrower will already have lost all of his equity and thus much of the incentive to continue making payments.  If prices recover, however, the lender recovers his losses first but the borrower will, if prices continue to rise, reclaim his lost equity as well.  While this arrangement shifts some of the house price risk from the lender to the borrower, decreasing the borrower's incentive to default, it also gives the borrower an incentive to stay in the home and the mortgage.  

The authors suggest basing value on some type of repeat-sales area index to eliminate the cost of individual appraisals and the temptation to the borrower to negatively impact the value of an individual house by damaging or not maintaining it.  An index also allows the lender to assess their systemic risk in a city or region.

The article compares the ABM to alternative methods suggested by others and lays out a number of scenarios using different pricing models, readjustment intervals, house price volatility levels, and suggesting hedging mechanisms that lenders could use to further reduce risk.  Through financial modeling and analysis, Ambrose and Buttimer determine that the adjustable balance mortgage would have a lower contract rate than the standard fixed-rate mortgage when the loan-to-value ratio is above 80 percent. Further, they find that their new mortgage provides lenders with an incentive to use a derivative contract to hedge against the risk of home price declines.

The authors also claim that their study shows why there is such a high rate of redefault in loan modification programs which currently rely on fixes that are structured primarily on borrower payment-to-income ratios. "The only way to truly reduce the default probability is to either reset the mortgage balance to a LTV that is lower than 100 percent, probably around 80 percent, or have frequent, predictable balance resets," Ambrose says. "The key implication is that the programs rolled out by U.S. regulatory authorities will not significantly reduce defaults unless house prices rapidly stabilize or go up, independent of issues such as moral hazard."