The Influence of Earnings Risk on Mortgage Terms and Performance

A feature of last decade’s mortgage crisis was that the credit risk of borrowers was not accurately priced into their mortgages. For example, the increased risk of delinquency was not associated with a higher interest rate. I confirm this belief by using a measure of earnings risk, a major source of risk at the household level. Higher levels of earnings risk measured at origination predict a greater probability of delinquency for borrowers who are granted a mortgage. Yet the relationships of earnings risk and predicted delinquency to loan terms are weak at best. Further results indicate that increases in earnings risk measured at origination (i) increase borrowers’ perceived risk of falling behind on payments and (ii) influences lenders’ restructuring decisions. Both findings are consistent with theories involving information problems and the former is also consistent with an expectations based view