Origination Channel, Prepayment Penalties and Default

Abstract

This article presents evidence that nonbank-originated subprime mortgages have a higher probability of default than bank-originated subprime mortgages, but only for loans with prepayment penalties. Evidence also indicates that nonbanks price prepayment penalties less favorably to borrowers than banks do, and nonbanks originate disproportionately more loans with prepayment penalties in locales with less financially sophisticated borrowers. State antipredatory lending law provisions restricting the use of prepayment penalties eliminate the elevated default risk of nonbank originations relative to bank originations. These findings are consistent with incentives generated by nonbank compensation via yield spread premiums on loans with prepayment penalties.Of broad concern for our understanding of the recent foreclosure crisis and for housing and financial stability moving forward is the role of compensation incentives across origination channels in mortgage lending. The specific aspect of this concern addressed in this article is whether and why subprime loans originated by relatively less-supervised nondepository institution mortgage originators ("nonbanks") performed worse than subprime loans originated by depository institutions ("banks") primarily supervised by one of the federal financial regulatory agencies: the Federal Reserve, Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation, Office of Thrift Supervision (OTS) or National Credit Union Association. 1 Results indicate that nonbank originations have a higher probability of default than bank originations, but only for loans that include prepayment penalties. This is the first evidence linking greater default risk across origination channels to a specific loan feature and is consistent with a greater importance of yield spread premiums (YSPs) in compensation among nonbank originators than bank originators. * University of Maryland, Baltimore County, Baltimore, MD 21250 and Office of the Comptroller of the Currency, Washington, DC 20219 or mrose@umbc.edu. 1 Many examinations of mortgage lending by origination channel distinguish between originations by direct lenders ("retail") and by brokers ("wholesale"). Here, nonbank originations include both broker originations and originations by direct lenders that are not depository institutions. As is explained in the data and methodology section, the use of this categorization of origination channel is determined by data availability. C 2012 American Real Estate and Urban Economics Association 2 RoseThe article then presents further evidence that disparities by origination channel in pricing prepayment penalties, borrower financial sophistication and the role of antipredatory lending laws are also consistent with differing compensation incentives.The remainder of this article consists of six sections. The following two sections provide background information and discuss the relevant previous literature. The next sections present the article's hypotheses, describe the article's data so...

Beyond the Transaction: Banks and Mortgage Default of Low-Income Homebuyers

“…There is growing evidence that mortgage loans originated by banks are less likely to default than similar loans originated by nonbank lenders (Alexander et al , Jiang, Nelson, and Vytlacil 2014, Rose ). Unlike banks, third‐party originators lack the regulatory controls to be held accountable for longer term mortgage outcomes, and may passively substitute quick turnaround for rigor in screening applicants, or intentionally inflate measures of credit quality or property value (moral hazard).…”

“…Unlike banks, third‐party originators lack the regulatory controls to be held accountable for longer term mortgage outcomes, and may passively substitute quick turnaround for rigor in screening applicants, or intentionally inflate measures of credit quality or property value (moral hazard). For example, Rose () finds that differing compensation incentives for brokers may drive down screening quality, as nonbank originations perform worst when prepayment penalties are included, which also have higher broker compensation. In an analysis of prime and subprime mortgages, Jiang, Nelson, and Vytlacil (2014) find that low‐documentation mortgages (often associated with brokers) have increased probability of default.…”

“…A growing body of research finds that borrowers with mortgage loans originated by depository institutions (henceforth, “banks”) are less likely to default on their mortgages than similar borrowers with loans originated by mortgage companies or brokers. Differences in loan characteristics between lender types explain some of this variation; however, studies have found significant differences in default even after controlling for loan and other observable borrower risk characteristics (Alexandar et al , Ding et al , Laderman and Reid , Moulton , Jiang, Nelson, and Vytlacil 2014, Rose ). The primary explanation for this difference is the regulatory environment of banking institutions, with more scrutiny over loan quality, minimum capital requirements, and stronger incentives to screen loan applicants (Alexander et al ; GAO Report to the Subcommittee on Oversight and Investigations, Committee on Financial Services, House of Representatives April 2006‐387).…”

The role of prepayment penalties in mortgage loans

“…Second, our analysis complements those that investigate whether prepayment penalties affect mortgage terms and may benefit borrowers (Dunn and Spatt, 1985;Rose, 2012;Mayer et al, 2013). Specifically, Mayer et al (2013) 145…”

“…Overall, prepayment penalties allow lenders to reduce this interest rate risk because they reduce borrowers' incentives to prepay their mortgages. Therefore, prior to the recent financial crisis, many mortgages included these penalties, most notably those offered to riskier bor-25 rowers (Mayer et al, 2013;Rose, 2012).…”