We present a continuous time option pricing model for mortgage valuation to examine the effects of a prepayment penalty on the default and the prepayment decision of subprime borrowers. We show that the options embedded in the mortgage contract have significant positive values for the mortgage borrower. In particular, the value of the prepayment option for the subprime mortgage borrower is significant. The major finding from this study is that the prepayment penalty affects not only the prepayment decision but also the default decision of subprime borrowers, by reducing the value of these options. The prepayment penalty increases the likelihood of default by subprime borrowers and makes refinancing prohibitively costly. These two effects induced by the prepayment penalty generate a high rate of mortgage defaults and foreclosures. Consequently, borrower defaults began to increase as house prices started to depreciate in 2006.
We are in the middle of an economy-wide financial crisis with the subprime mortgage market at the epicenter of the crisis. The first sign of trouble was a sudden increase of default in the subprime mortgage market with a drastic house price depreciation in 2006. What caused this sudden increase in default rates in the subprime mortgage market after many years of high prepayment rates? This paper is an attempt to answer this question. This is of interest to academics, policy makers, and the general public.
We present a continuous time version of an option pricing model for mortgage valuation to examine the effects of a prepayment penalty on the default and the prepayment decisions of subprime borrowers. Our study shows that a sudden increase of default in the subprime market is caused by the prepayment penalty, that is prevalent in subprime mortgage contracts, along with house price depreciation. These two together have generated a perfect storm in subprime mortgage market.
This paper demonstrates that the prepayment penalty has two effects on the subprime borrower’s mortgage termination decisions. The prepayment penalty makes prepayment or refinancing prohibitively costly. Equity extraction from house price appreciation is the key to the subprime mortgage design. And this equity extraction from house price appreciation is only possible through the prepayment. With a high prepayment penalty, this prepayment option is not available to the subprime mortgage borrowers.
The options embedded in mortgage contracts add economic value to the mortgages since these options provide partial protection from the volatility of house prices. In particular, the value of the prepayment option for the subprime mortgage borrower is significant. The prepayment penalty increases the likelihood of default by subprime borrowers because the penalty reduces the option values of the mortgages. By these two effects of the prepayment penalty, the subprime borrowers become more vulnerable to default caused by the house price depreciation. This inability to refinance mortgage loans and the high default point, induced by the prepayment penalty translated into a high rate of mortgage defaults and foreclosures. Consequently, borrower default began to increase as house price started to depreciate in 2006.
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The Effect of Prepayment Penalties on Subprime Borrowers Decisions to Default: A Perfect Storm
