Information Asymmetry and Residential Mortgage Choices

When financing real estate properties through a mortgage, borrowers often face a variety of loan products. During the recent housing bubble the variety of mortgage products and features proliferated. The recent mortgage foreclosure crisis leads many commentators to point to the growth in the use of these alternative mortgage features as being predatory. A number of academic studies provide supporting evidence to this view. In contrast, economists have long noted that mortgage menus provide an effective mechanism for reducing the information asymmetry that exists between borrowers and lenders. This dissertation focuses on the screening mechanisms of mortgage features. One of the goals is to analyze the welfare implications of allowing for a greater variety of loan products in the residential mortgage market.This dissertation also aims to contribute to the existing literature on mortgage choices by incorporate multiple risk dimensions in a unified framework. Most previous studies limit their exploration to a single risk dimension, default or prepayment risk. While examining one risk dimension at a time substantially simplifies the analysis, it also omits the fact that multiple sources of information asymmetry may be at work in shaping the mortgage market equilibrium. It is well-known that a mortgage contract contains two types of risk: default risk and prepayment risk. A single device may possess dual screening roles.Chapter 2 of this dissertation illustrates the screening role of prepayment penalty on default and prepayment risks. It examines the interaction between the two screening functions of prepayment penalty, and shows that the borrower mobility and default risks jointly determine the mortgage market equilibrium. In particular, the willingness of a borrower to accept a prepayment penalty may stem from her low mobility risk and/or high default risk. The choice of a higher prepayment penalty sends the lender conflicting signals about the borrowers mobility versus default risk type; thus rendering the screening role of prepayment penalty ambiguous. Chapter 3 studies the dual screening role of mortgage discount points. It shows that there exists a separating equilibrium such that borrowers with higher (lower) transaction costs pay more (less) discount points to obtain a lower (higher) interest rate. This theoretical prediction suggests a new screening function of mortgage points, and it complements the conventional mobility-based theory that suggests that the choice of discount points is a signal of the borrowers expected mobility. Chapter 3 also empirically examines the screening role of discount points from the lenders perspective. The empirical results suggest that lenders tend to securitize loans originated by borrowers with higher transactions cost. Chapter 4 offers a theoretical model to show that when future income uncertainty is private information, there exists a separating equilibrium such that borrowers with higher default risk are more likely to choose mortgage contracts with prepayment penalties. I further test the prediction of my model using a sample of securitized mortgages that contain loans with and without a prepayment penalty. I find that the positive correlation between prepayment penalties and default rates is attributable to information asymmetry.