Are Underserved Borrowers Lower Risk? New Evidence on the Performance and Pricing of FHA-Insured Mortgages

While prior analyses have provided evidence of elevated default probabilities among mortgages originated to lower income, less credit worthy, and minority populations, those risks may be offset by the reduced prepayment probabilities of those loans. Such offsets could serve to reduce the total termination risk of loans originated among underserved populations and enhance the willingness of lenders and investors to originate and acquire such loans at more competitive pricing. This paper employs micro-data from the FHA to estimate an option-based hazard model of the competing risks of mortgage termination. The empirical model derives from option theory and includes controls for the contemporaneous value of mortgage put and call options, borrower credit worthiness, and a large number of other indicators of borrower, loan, and locational risk. Monte Carlo methods are employed to simulate the term structure of interest rates and to assess the pricing implications of the performance analysis. Results indicate that the elevated default probabilities of loans originated to lower credit quality and minority borrowers are more than offset by their reduced prepayment risks. The estimated 5-year cumulative probability of mortgage termination among lower credit-quality and minority borrowers is only about three-fourths that of higher credit-quality and white borrowers, respectively. In a declining interest rate environment, those damped termination risks translate into a simulated 90 basis point reduction in yield to lower credit-quality mortgage pools. Findings suggest that similar pooling and risk-based pricing of FHA-insured mortgages could serve to substantially reduce the housing finance costs of underserved borrowers, so as to advance both their homeownership opportunities and related federal housing policy objectives.