Delinquency and default in ARMS the effects of protected equity

Chapter One Introduction

1.1 Background

Mortgage Lending is an imperative component of the businesses of financial institutions
worldwide. This is accelerated by the growth of the private residential property markets
in the respective countries. In the US, almost half of the mortgages are securitized as
Mortgage-backed Securities (MBS) (Deng, Quigley and van Order, 2000). Similar trends
can be found in Singapore. With Singapore’s de facto central bank, Monetary Authority
of Singapore recommending the securitization of real estate (Sing and Ong, 2004) and the
provision of favorable tax treatment for such issues (Ong, Ooi and Sing, 2000), there is
enormous potential for the secondary mortgage market to take off in Singapore. In
accordance to these trends, the roles and abilities of mortgage servicers in controlling
default outcomes become increasingly crucial.

Understanding the various types of mortgage risk is thus essential, for both practitioners
and academics. For practitioners, the credit risk management functions of financial
institutions are essentially geared towards assessing the credit or default risk of customers
i.e. the possibility of a borrower not being able to service a loan. On the other hand, to
mitigate prepayment risk and share interest rate risk with borrowers, lenders are
increasing moving towards issuing adjustable-rate mortgages (ARMs). In academia,
default risk (e.g. Quigley and Van Order, 1990), prepayment risks (e.g. Ong, 2000; Lee

1


and Ong, 2006) and the competing relationship between them (e.g. Deng, et al., 2000;
and Clapp, Deng and An, 2004) are areas of intense study.

However, studies on mortgage delinquency and the incorporation of delinquency in
overall mortgage risk models are far and few. This can be attributed to a lack of suitable

available data (Von Furstenberg and Green, 1974), difficulties in modeling delinquency
within the prevailing option-based approach (Quercia and Stegman, 1992), and
perception among practitioners that the financial consequences of delinquency is less
severe than default (Quercia, et al., 1992). Understanding delinquency risk will also help
practitioners better determine the default risk of their portfolio.

In this paper, we deem mortgage delinquency as a significant and necessary decision that
is taken by the borrower prior to the default decision. Accordingly, we propose that the
motivations for delinquency exert a significant influence on the subsequent motivations
for default such that default risk models should incorporate the risk of delinquency.

Among the factors affecting the risk of default and delinquency, the extent of the
borrower equity is considered one of the most important variables (Kau, et al., 1993 and
1994, and Lambrecht et al., 1997). In Singapore, the use of CPF savings (a compulsory
retirement savings scheme) to pay for the initial housing downpayment and the
repayment of the mortgage loan is prevalent. Before September 2002, the CPF Act
guarantees the CPF savings utilized such that when the house is subsequently sold either
for foreclosure or relocation, the sale proceeds must be used to repay the CPF savings

2


first before being utilized to repay the mortgage balance with the financial institution.
Interests foregone must also be returned to the retirement accounts. Thus, the portion of
borrower equity financed by CPF savings is “protected”. We postulate that the impacts of
“protected equity” on the risks of default and delinquency performances are different
from conventional measures of borrower equity financed by cash savings. This provides a
natural experiment for us to investigate the role of government policy and the role of
borrower equity in affecting mortgage risks.

1.2 Definition of Mortgage Delinquency & Default

It is crucial to define and differentiate delinquency and default at this early stage. There is
a lack of consensus on this aspect. Earlier scholarly works (von Furstenberg and Green,
1974; Campbell and Dietrich, 1983; and Zorn and Lea, 1989) differentiate them
according to the eventual outcome. Loans with missed payments that are eventually
repaid are defined as delinquent while loans that are eventually foreclosed are defined as
default. These papers focus on studying the latter and assume that default is synonymous
with foreclosure. This differentiation is only possible with hindsight and is not useful for
lenders and servicers, as they cannot differentiate between the two at the time when
missing the first mortgage and thus undertake suitable strategies. These studies also do
not differentiate between different motivations of defaulters – those who miss payments
with the intention of giving up their properties and do eventually foreclose, and those
who miss payments with the intention of reinstating their mortgages but were eventually
unable to prevent foreclosure.

3


The second group of studies, developed by Vandell (1993) and later in the works of
Ambrose, Buttimer and Capone (1997), Ambrose and Capone (1996, 1998 and 2000),
Ambrose and Buttimer (2000), Deng (1997) Deng, et al. (2000) and Phillips and
VanderHoff (2004) included the distinction between default and foreclosure in their
models. Foreclosure is regarded as one of the possible paths a defaulted loan can take.
However, this group of papers classifies loans as default once a scheduled payment is
missed. Therefore, no distinction is made between delinquency and defaults.

On the other hand, practitioners in the US and Singapore1 differentiate delinquency and
default by the number of days of missed installments. Delinquency is defined as the
nonpayment of a mortgage payment due (e.g. Ambrose and Buttimer, 2000; and Holmes,

2003). Default occurs when a borrower has missed 90 days’ installment and the fourth
payment is due (Ambrose and Capone, 2000; and Chen and Deng, 2005). This is also
sometimes termed serious delinquency. Therefore, delinquency is a necessary precursor
to default. During delinquency, the lender usually sends reminders to the borrower to
make up the missed payments. Although the lender has the right to foreclose the property
as missing an installment is tantamount to a breach of contract, he would usually refrain
until default. Thus, the borrower has the option to repay the missed installments and
reinstate the mortgage. Once the loan transited to default, the lender will issue a formal
legal letter to the borrower indicating the lender’s right to proceed with foreclosure
1

This definition is supported by Section 25 of the Conveyancing and Law of Property Act in Singapore,
which states that "A mortgagee shall not exercise the power of sale conferred by this Act unless - notice
requiring payment of the mortgage money has been served on the mortgagor or one of several mortgagors,
and default has been made in payment of the mortgage money or part thereof for 3 months after the
service…”

4


proceedings any time from then on. The commencement of foreclosure proceedings is
significant because borrowers are generally not able to reinstate their delinquent loans
once the foreclosure sale occurs (except for some states). Thus, the borrower faces real
danger of losing his home with the transition to default. Using this terminology, there are
two unambiguous decision points i.e. 1) whether to delinquent, and 2) once in
delinquency, whether to default. We adopt this set of definitions in our paper.

Besides the significance of the crossover from delinquency to default, this definition is
also useful in differentiating optimal and trigger-event defaulters via different initial
motivations of delinquency and default. Optimal defaulters refer to borrowers who

delinquent to maximize their wealth when their mortgages are in negative equity
positions. They will transit to default unless there are favorable changes in their equity
positions2. Trigger-event defaulters refer to borrowers who delinquent due to some
exogenous events and have every intention of reinstating their mortgages. They will
avoid default unless the impacts of the trigger-events have seriously affected their
financial ability to reinstate. The differing motivations of the two categories of defaulters
are elucidated by the practitioners’ definition as shown in Exhibit 1.

2

This follows from Ambrose and Capone (1998), which offers similar arguments for the transition from
default to foreclosure.

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Exhibit 1 Differing Motivations of Delinquency and Default

Optimal

Trigger-event

Delinquency

Time

Default

Financial difficulties
in paying installments

due to exogenous
events

Financial position not
improved sufficiently
to enable reinstatement

Wealth maximizing to
delinquent due to
negative equity
position

No favorable changes
in net equity position
to support
reinstatement

1.3 Research Problems & Objectives

The unique feature of the mortgage market in Singapore is the use of borrowers’
retirement funds or CPF savings to finance the purchase of residential properties. With
protection being conferred by regulations to the CPF portion of borrower equity, this
provides a natural experiment to investigate the role of government and the role of
protected borrower equity in controlling mortgage risk. As mentioned, borrower equity is
found to be an important variable of default decisions in past mortgage literature.
Furthermore, the effect of protected borrower equity on mortgage risk is likely to be
different from the conventional borrower equity, which can be lost if foreclosure occurs.
However, this disparity has not been addressed by past mortgage studies. Therefore, the
first research question of our paper aims to examine the impact of protected equity from
different angles and perspectives.

6


From the academia point of view, providing insights into a different variant of borrower
equity is significant towards contributing to the overall knowledge of borrower behavior
and the influence of equity on mortgage risks. It also shows how government policy and
regulation can manipulate the default and delinquency performances of mortgages and
their securities.

More practically, understanding the effects of protected equity is significant to policymakers and advocates of pension fund reforms. As pension funds are being liberalized or
reformed, the use of such funds to finance the purchase of housing may become a
possibility. This will probably be advocated to improve the accessibility and affordability
of homeownership. The Singapore experience, where pension funds are allowed to
finance home purchases and to service the monthly mortgage installments, provides an
opportunity to investigate the potential impacts of such a policy on mortgage risk.
Equally important to local context, the direction and strength of the relationship between
the use of CPF savings and the risk of default will likely provide an answer to whether
the policy of allowing CPF funds to partially furnish the mortgage is a bane for mortgage
securitization in Singapore. Despite tax incentives and regulatory liberalizations,
Singapore has yet to see its first MBS. It is generally believed that the use of CPF savings
is holding up securitization of mortgages. The main reason is the regulation that stipulates
the CPF Board as having first lien on the properties. This implies that private lenders will
then have secondary claims on the properties3. However this preconception has not been
tested as yet. A better understanding of the effects of the protection conferred to the
3

However, this has recently been amended in September 2002.

7

retirement funds used will provide support for further development of Singapore’s
securitization market.

Therefore, the study’s first contribution is the understanding of the role of government
policy and of protected equity in controlling default and delinquency risks.

Based on the definitions adopted in this paper, there is a seemingly obvious relationship
between delinquency and default. Firstly, the essential preceding step of a defaulting
mortgage is delinquency. Secondly, as iterated in Exhibit 1, the motivation for default is
essentially originated from the motivation for delinquency. For instance, Waller (1989)
found that lengthy delinquency period might cause borrowers to accumulate so much
back payments that default becomes unavoidable. Thus, the relevant observed and
unobserved variables for delinquency and default are likely to be related. As a result,
Quercia, et al. (1992) advocated the study of default decision within a framework that
incorporates the delinquency decision. However, no studies have tested or taken into
account the potentially influential relationship between default and delinquency4. Thus,
the second research question of our paper contends with the presence and significance of
such a relationship.

The importance of the research question is derived from the absence of the delinquency
decision in existing default models. If a significant relationship can be proven to exist
between the two decisions, such default models can be deemed to be mis-specified and

4

Except for a recent working paper by Chen and Deng (2005) that recognized the transition from
delinquency to default.

8


inefficient. It would also be necessary to incorporate the delinquency option to mortgagepricing models. By examining whether such a relationship exists, our paper aims to
expand the existing knowledge of borrower behavior.

More practically, lenders and servicers often ignore delinquency and focus their attention
on controlling default risks. As delinquency is the essential preceding step of default and
the effects of their determinants may be different, it may be more efficient to engage
different risk mitigation tactics in different stages, i.e. whether they are in delinquency or
have transited to default. Lenders and servicers will thus be able to alter borrower
behavior in delinquency through the appropriate loss mitigation programs. In addition, it
may be necessary to predict the delinquency and default performance of mortgage pools
in order to effectively price them and determine the appropriate subsequent actions.

Thus, the second and third contributions of this paper are to verify the presence of a
significant relationship between mortgage delinquency and default, and to identify
whether the sequential nature of delinquency and default does exert a significant impact
on default decision modeling.

Provided that the relationship between delinquency and default is found to be significant,
the obvious next step would be to examine the default/reinstatement behavior of
borrowers after taking into account the effects of delinquency. Previous studies mostly
focus on the post-default outcomes, i.e. the conditional risk of foreclosure given default
(e.g. Ambrose and Buttimer, 2000), rather than the default behavior itself. These studies

9


also ignore pre-default influences e.g. the potential influence of delinquency on default

behavior. Therefore, we intend to examine this pre-default influence in our study. More
critically, no past research has focused specifically on reinstatement behaviors. Although
reinstatement after delinquency is the direct opposite of default, placing emphasis on the
former allows us to view the issue from a different, and perhaps more interesting point of
view. Therefore, the third research question relates to the determinants that influence
whether a borrower reinstates or transits to default after taking into account the predefault influence of delinquency.

By examining the reinstatement question, we are essentially looking at the default
question from another angle or point of view. This is expected to provide insights to
borrower behaviors, adding on to our existing knowledge. Furthermore, this research
question is significant to lenders and servicers. When a loan missed a first payment, it is
important to lenders and servicers to assess its likelihood of reinstatement. Subsequently,
they can identify and focus their efforts toward loans that are more likely to transit to be
reinstated. This enables a more efficient allocation of resources and also mitigates the risk
of foreclosure by increasing the probability of reinstatement. In addition, the income
earned by servicers is the spread between payments collected and funds paid to MBS
investors. With insights to the characteristics of delinquent loans that are more in risk of
delaying payment for a longer period of time by transiting to default, servicers can better
predict their income and also act on these riskier loans.

10


Thus, the fourth contribution is to provide pioneering insights to the reinstatement
behavior in a conditional probability of reinstatement framework that assumes a
significant relationship between default and delinquency.

The impact of repeat delinquency or default is under-researched in existing mortgage
literature. Ambrose and Capone (2000) is the first paper to examine the issue of whether
the default risk of mortgages that have avoided foreclosure on an initial default (or

reinstated) is similar to those that have not previously been defaulted. The paper found
that the prediction of default risk for the two groups is different. Essentially, the
probability of default for the former is higher, especially during the first two years after
the initial reinstatement from default. After the two-year period, the default rates for the
two groups are similar but the volatility of repeat defaulters is higher. In addition,
economic variables are more influential in predicting default in the former group.
Following Ambrose and Capone (2000), the third research problem of our paper
examines the postulation that the risk of default and delinquency is different between first
time delinquents and repeat delinquents who have reinstated from previous
delinquencies. To test this hypothesis, we include a dummy variable to indicate loans that
has previous delinquency experiences.

The relative riskiness of repeat delinquents compared to first-time delinquents enables a
more detailed understanding of borrower behavior. Taking into account their
heterogeneity, mortgage risk modeling can be further improved. Furthermore, lenders and
servicers are concerned about whether previous delinquency experiences are indications

11


of greater riskiness of subsequent defaults. They may want to focus their resources on
first-time delinquents or have different strategies for different groups to try to reduce the
transition to default. Ambrose and Capone (2000) also suggested important implications
of their research to the riskiness of MBS, the income of mortgage servicers, and the
success of the loss mitigation program of the FHA. Similarly, these implications are also
applicable to our study of repeated delinquencies.

The fifth contribution of our study is the verification of the presence of a differing risk
profile and behavior for a first time delinquent and a repeat delinquent.

In responding to the research questions, we test five aspects of the borrower delinquencydefault behavior:
1. the role of the government and the role of borrower equity in affecting the risk of
delinquency and of default;
2. the presence of a significant relationship between delinquency incidence and
subsequent default decisions;
3. the disparity in the expected behavior of borrowers in a model that takes into
account the relationship between delinquency & default as compared with a
model that assumes no such relationship exists;
4. the borrowers’ decision to reinstate or to allow transition to default given
delinquency; and
5. the probability of default for reinstated/repeat-delinquent borrowers as compared
to first time delinquents.

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To preview our findings, we found that:
1. the use of protected borrower equity to help finance housing purchases is shown
to increase the risk of default when its use at origination increases, but the risk of
default is decreased as the protected equity is accumulated over time;
2. the relationship between delinquency and default is highly significant and should
be included in subsequent default risk modeling;
3. variables like the probability of negative equity, mortgage term, tenure and land
area of the property, and the number of co-borrowers have inverse relationships
with regards for a model that takes into account the relationship as compared to a
model that does not;
4. the borrowers’ decision to reinstate a delinquent mortgage depends on a number
of variables like the initial loan-to-value ratio, whether borrowers can service the
mortgage entirely via the retirement fund contributions and occupation, and the
influential determinants can sometimes be different from the unconditional

default behavior; and
5. the risk profile of borrowers with previous experiences of delinquency is found to
be different and riskier than borrowers who are first-time delinquents.

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1.4 Organization of Report

Chapter Two provides a review of related literature, followed by a brief introduction to
the CPF Scheme in Singapore in Chapter Three. The next chapter describes the research
methodology and data for the intended analyses. Chapter Five examines the relationship
between delinquency and default, and the impact of repeated delinquency on subsequent
default behavior. In addition, the chapter also examines the effects of protected borrower
equity Chapter Six investigates the conditional risk of reinstatement given delinquency.
Finally, Chapter Seven concludes the study.

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Chapter Two Literature Review

2.1 Introduction

It is necessary to note that most literature on mortgage risks was originated from the US,
where Fixed Rate Mortgages (FRMs) are prevalent (Ong, 2000). Conversely, all
mortgages originated in Singapore are ARMs (Khor and Ong, 1998). The exogeneous
and endogeneous factors affecting both forms of mortgages may thus diverge. For
instance, the prepayment risk for Singapore mortgages is very low (Ong, Maxam and
Thang, 2002) while the prepayment risk for ARMs in US may be higher resulting from

potential switches to FRMs to take advantage of interest rate movements (Ambrose and
LaCour-Little, 2001). However, Campbell, et al. (1983) found that most determinants that
affect default decisions influence delinquency in the same way. Therefore, the methods
and factors used in the literature to rationalize mortgage risks in FRMs serve as a
platform for our analysis.

2.2 Methodologies of Mortgage Risk Studies

Mortgage risk studies essentially started in the early 1960s and the main methodologies
used included regression (von Furstenberg and Green, 1974; Morton, 1975; and
Campbell, et al., 1983), logit (Vandell and Thibodeau, 1985), and multinomial logit
(Zorn, et al., 1989; and Cunningham and Capone, 1990). Such models often suffer from a

15


lack of theoretical basis for the borrower behaviors. This led to the development of the
Borrower Payment Model and the Option-based Model.

Mortgage risk studies that utilize the options-based theories to explain default and
prepayment behaviors focus on the net equity position i.e. the house price movement and
the term structure. These two factors are postulated to be the main determinants of such
behaviors (Kau, Keenan, Muller and Epperson, 1992; Kau, Muller and Epperson, 1993;
Kau, Keenan and Kim, 1993 & 1994; Ambrose, Buttimer and Capone, 1997; Ambrose
and Buttimer, 2000). However, earlier options-based studies failed to take into account
the competing nature of foreclosure and prepayment.

Thus, more recent studies utilize the competing risk model employed by Deng, et al.
(2000) to incorporate a wider range of default factors like borrower characteristics
(Ambrose and Capone, 2000; Ong, et al., 2002; Lambrecht, et al., 2003), macroeconomic

characteristics (Ambrose and Capone, 2000; Ambrose and LaCour-Little, 2001; Ong, et
al., 2002) and loan factors (Ambrose and LaCour-Little, 2001; Ong, et al., 2002). These
mostly utilize the Cox proportional hazards model. This model is similarly utilized in a
more recent paper (Chen and Deng, 2005).

In addition, Ambrose and Capone (1998) and Phillips, et al. (2004) use a multinomial
logit model to test the influence of borrower, mortgage and macroeconomic variables on
the conditional probability of foreclosure. The former relied upon the options-based

16


approach to identify the independent variables while the latter included the variables that
they believe to be significant.

2.3 Variables of Delinquency and Default Decisions
2.3.1 Determinants of Mortgage Delinquency

Ambrose and Capone (1996, 1998) and Waller (1988) described the aim of delinquency
is either to put the funds, originally intended to pay the installments, to other uses due to
financial difficulties, or to exercise the implicit put option to abandon the property. A
third cause of delinquency noted by Waller (1988) is the economic incentive borrowers
can gain from living in the house rent-free before foreclosure takes place.

Only a handful of studies are conducted to examine the determinants of delinquency. Von
Furstenberg, et al. (1974) found that the equity-value ratio possesses a significant
negative relationship with delinquency while the age of mortgages has a positive
relationship. For instance, as the loan-to-value ratio increases from 80 to 90 per cent, the
delinquency rate escalates by about two-thirds, and when the ratio further increases to 95
per cent, delinquency rate would increase by another 70 per cent.

In addition, mortgages of existing houses are more prone to delinquency than those taken
on new houses. Herzog and Earley (1970) and Morton (1975) also found income,
occupation and the number of children to be influential determinants. In particular, von

17


Furstenberg and Green (1974) discovered that when household family increased from
US$5000 to US$10,000, the delinquency rate declines by 31 per cent.

Zorn, et al. (1989) argued that delinquency can be regarded as a form of borrowing from
the lender at the mortgage contract rate. Therefore, when interest rate increases,
delinquency rate will correspondingly rise as people “borrow” at the relatively cheaper
source of fund to finance other uses. Canner et al. (1991) found that the receipt of
government assistance, headed by a minority, and martial status have positive influences.

On a more somber note, Canner et al. (1991) pointed out that delinquency prediction
consists of a large unexplained random component as credit problems can arise from
events that are difficult to foresee. Thus, the use of ex-ante data has the ability to capture
components that systematically affect delinquency and are observable to the lender at
loan origination but ignores the more unpredictable ex-post components.

Campbell, et al. (1983) did a comparison between the determinants of delinquency and
default rates and verified that household income and interest rate are more influential
than equity measures because they represent the availability and opportunity costs of
funds used to repay the mortgage installments. They also expected the loan-to-value ratio
to be less important than for default incidence because delinquency is without potential
termination of ownership of the property, although their results differ.

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2.3.2 Determinants of Mortgage Default

Mortgage Loan Specific Characteristics

Literature on mortgage loan specific characteristics traditionally focuses on the equity
position of the borrower, which has generally been found to be significant. This is
coherent with earlier studies where the borrower is assumed to default once negative
equity position is reached whereby the value of the property falls below the mortgage
value. Transaction costs and other costs associated with default/ foreclosure were ignored
in these studies.

Several proxies of the equity position of borrowers were used. Herzog and Earley (1960)
and von Furstenberg (1969) were among the first studies to use the loan-to-value ratio at
origination and to endorse its dominance. Other studies that use the loan-to-value ratio
include Von Furstenberg and Green (1974), Vandell (1978), Schwartz and Torous (1993),
Kau, et al. (1993, 1994) and Lambrecht et al. (1997). Campbell and Dietrich (1983)
attributed its significance to the high correlation between the initial and subsequent loanto-value ratio, and to it acting as a proxy for borrowers’ non-housing wealth.

Several studies employ the current loan-to-value ratio as a measure of equity including
Follain and Struyk (1977), Campbell and Dietrich (1983), Vandell and Thibodeau (1985),
Anderson and Weinrobe (1986), Cunningham and Capone (1990), and Capozza et al.
(1997). A study to compare the relative importance of the initial and current loan-to-value

19


ratio was undertaken by Waller (1989). It was found that although the latter ratio had a

greater influence on foreclosure decision, the two ratios are significantly correlated.

Other proxies used include the value-to-total debt ratio (Waller, 1988; Zorn and Lea,
1989; Springer and Waller, 1993) and book value (Giliberto and Houston, 1989;
Hendershott and Schultz, 1993). Specifically, Springer and Waller (1993) adopted three
measures of equity namely, property value-to-total borrower debt ratio, property value-tomortgage value ratio, and property value-to mortgage balance ratio. It was found that the
first measure using total borrower debt was more effective in explaining the default rate
than the other two.

Most studies found that equity measures are positively significant in explaining the
default/ foreclosure rate. In contrast, Foster and Van Order (1984), Zorn and Lea (1989)
and Lambrecht et al. (1997) found that equity measure is negatively correlated with
default/foreclosure rate with a low level of significance. The first two studies attributed
these to reluctance among the borrowers to default even under negative equity situations.
It is interesting to note that the latter two studies utilize ARMs data from outside the US,
i.e. Canada and the UK, respectively.

Von Furstenberg (1969 and 1974), who was among the first to use the age of mortgage as
a determinant, found it to be significant and that foreclosure rates peaked three to four
years after origination and will decline until they become negligible when about half the
mortgage term expired. This is similar with Waller (1989), Schwartz and Torous (1993)

20


and Kau et al. (1994) whereas Campbell and Dietrich (1983) discovered a peak at 6.7
years. Vandell (1978) found the peak of foreclosure for ARMs to be between the 2-5
years.

With regards to the signs of influence, contradictory results are obtained. Furstenberg

(1969), Vandell (1978) and Campbell and Dietrich (1983) using log age and Cunningham
and Capone (1990) using quadratic function of age found a negative correlation. Springer
and Waller (1993) attributed this to the higher level of principal repayment and equity
build-up as more payments are made. On the other hand, studies that use age directly as a
variable mostly found a positive relationship (Furstenberg, 1969; Vandell, 1978;
Campbell and Dietrich, 1983; Cunningham and Capone, 1990 and Capozza et al., 1997).
This is attributed to a close correlation between age and other determinants of foreclosure
determinants.

Mortgage term is found to have a significant direct relationship with the default/
foreclosure rate (Furstenberg, 1969; Herzog and Earley, 1970; Bervokec et al., 1994).
Specifically, Furstenberg (1969) attributed the positive correlation to the faster equity
build-up in shorter-term mortgages.

With regards to the effect of mortgage rate, consistent results were lacking in the
literature. The relationship between an ARM mortgage rate and the corresponding
default/ foreclosure risk is found to have a low negative elasticity (Zorn and Lea, 1989).
In contrast, Vandell, et al. (1993) and Ambrose and Capone (1996 and 2000) discovered

21


a low positive relationship. Riddiough and Thompson (1993) found that the impact of
interest rate is minimal when compared with other factors like property and mortgage
contract.

Property Specific Characteristics

Property related factors examined include the returns from property, the price volatility of
the property, age and the neighborhood quality.

Returns from property are often divided into capital appreciation and rental yield. Capital
appreciation as estimated by the difference between the current property price and the
purchase price, is found to have a positive significant relationship (Waller, 1989;
Vandell, 1992; Schwartz and Torous, 1993; Kau et al., 1994; Case and Shiller, 1996).
However, Lea and Zorn (1986) using the ratio of property price index to the consumer
price index, found it to be insignificant.

Capozza et al. (1997 and 1998) uses the rent-to-price ratio to evaluate the influence of
rental yield. Both studies found a significant negative relationship but suggested the
limited economic impact. Capozza et al. (1998) highlighted that there are two offsetting
effects relating to a higher rental rate. A higher rent implies a lower capital appreciation,
which increases the probability of reaching the default boundary. On the other hand, a
higher rental rate makes the existing mortgage on the property financially more attractive
relative to renting.

22


In addition to the returns from property, the volatility of property price is also an
important factor of default/ foreclosure rate. In a comparison study, Schwartz and Torous
(1993) found that when measured up against the cumulative housing index returns,
volatility of the index is more significant in explaining the rate of default. This is
attributed to the fact that a property price index captures the average prices whereas
default depends on the lower tail of the distribution. However, the literature does not have
consistent findings on the influence on default/ foreclosure rate.

Capozza et al. (1997) measured the volatility using the standard deviation of the time
series of the percentage price changes. Consistent with other studies (Schwartz and
Torous, 1993; Capozza et al., 1998; Ambrose and Capone, 2000), they found a positive

relationship. In contrast, Kau and Kim (1994) pointed out that when the volatility of
house price increases, the probability of default in the next period will decrease. This is
because the expected house price changes make waiting more valuable. On a similar
note, Clauretie (1987), Zorn and Lea (1989), Canner et al. (1991), Gabriel and Rosenthal
(1991) and Kau et al. (1994) also found a negative relationship with the rate of
foreclosure.

Capozza et al. (1998) found that the effect of house price volatility interact with the level
of current loan-to-value ratio such that when the ratio is low, there is a positive
relationship, and when the ratio is high, the impact is negative and high. Kau et al. (1994)

23


discovered that even with significant house price volatility, the probability of default
becomes negligible very quickly when transaction costs increases.

Vandell et al. (1993) found that the type of property is a significant determinant and that
hotel, office and apartment properties possess the highest default/ foreclosure rates while
retail and industrial properties have the lowest risks. Bervokec, Canner, Gabriel and
Hannan (1994) found that condominium properties were most risky among the various
residential property categories. Hakim and Haddad (1999) suggested a higher default risk
occurring for borrowers of new condominiums.

Mortgages on new houses were discovered to have higher rates of default than that on
existing houses (Furstenberg, 1969, Campbell and Dietrich, 1983). Similarly, the age of
the property is found to have a negative relationship with default rate (Canner et al., 1991
and Hakim and Haddad, 1999). However, Vandell and Thibodeau (1985) demonstrated
the insignificance of this variable.

Neighborhood quality is basically adopted to reflect the price variability of a location.
Canner et al. (1991) use residential vacancy rate and median age of housing stock as
measures for neighborhood quality while Carroll, Clauretie and Neil (1997) use the
location zip codes. Similar with these studies, Vandell and Thibodeau (1985) showed that
neighborhood quality is influential in explaining the default rate in a negative
relationship.

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Borrower Specific Characteristics

Previous studies generally found borrower related characteristics influential in explaining
the default/ foreclosure rate. However, there is no uniformity in the set of variables that
are statistically significant. Ambrose and Capone (1998) further argued that there exist
different categories of defaulters with differing motivations to default and thus, different
probabilities. Some of the variables used include ability to pay measures, household
income, previous history of delinquency or default, number of years of tenure of the job
and occupation.

Borrower’s ability to meet the periodic mortgage payments is a prevalent factor that has
been widely researched. The payment-to-income ratio is a popular measure but yields
inconsistent results. Vandell (1978) and Campbell and Dietrich (1983) found a positive
relationship while other studies found a negative relationship (Vandell and Thibodeau,
1985, Springer and Waller, 1993, Cunningham and Capone, 1990).

Age of the owner has also produced ambiguous findings regarding the extent and
direction of its influence. Furstenberg (1969), using the age of the principle mortgagor,
discovered a negative non-linear relationship with the default rate. Capozza et al. (1997)
found age to be a major determinant of default. Canner and Luckett (1990), whose study

included both consumer and mortgage loans, again used the age of the household head
and found it significant.

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