Kerry D. Vandell

Estimation of Mortgage Defaults Using Disaggregate Loan History Data

This paper addresses, theoretically and empirically, the structure of influences affecting the default option in mortgage contracts. A formal theoretical model recognizes that a number of loan and non-loan related effects beyond equity in the unit could influence the default decision. These include 1) payment levels relative to income, which could displace other investment opportunities or cause a need for borrowing or sale to meet mortgage obligations; 2) current and expected neighborhood and housing market conditions, in particular the expected relative rate of appreciation of the unit and the relative cost of homeownership; 3) economic conditions; 4) wealth; 5) borrower characteristics proxying for variability in income or crisis events; as well as 6) transactions costs incurred upon default. Estimates of the model making use of a micro-level sample of individual loan histories over a twelve year period, supplemented by longitudinal census and economic information, find a number of these other effects important. Simulations find several of them to dominate the equity effect on default and to help explain why some households with zero or negative equity may not default, while others with positive equity may. The implications of these results for appropriate specification of the pricing model describing the default option and for appropriate underwriting of AMIs are noted. Copyright American Real Estate and Urban Economics Association.

The Economics of Architecture and Urban Design: Some Preliminary Findings

This paper makes a preliminary attempt to evaluate empirically the nature of the contribution of architectural quality to the value of buildings. An economic model is postulated that predicts equilibrium rent and vacancy behavior as a function of both design and non-design characteristics. Vacancies are created in equilibrium as a result of search and information costs and tenant heterogeneity and are observed by the landlord as price-inelastic demand behavior. Design quality is seen to influence both rent and vacancy behavior. Its effect, however, is dependent on characteristics both of the production and operating cost functions and of tenant demand for the design vs. non-design amenity. An important characteristic of the design amenity is that it is not, in general, independent of the production function for non-design amenities. The model is tested using disaggregate cross-sectional and longitudinal operating performance and amenity data from a set of 102 class A office buildings in Boston and Cambridge. Data on design quality for the set of buildings were provided by a detailed evaluation of each structure by a panel of architects. Results confirm a strong influence of design on rents; structures rated in the top 20% for design quality were predicted to extract almost 22% higher rents than those rated in the bottom 20%. In contrast, the data showed a weak relationship between vacancy behavior and design quality. Finally, good design was shown to cost more to produce on average, but not necessarily in every case. The magnitude of the point estimates of the rent, vacancy, and construction cost effects suggest that good design may not in fact be more profitable on average, but as with a lottery, may provide a small probability of a high return to the developer. Copyright American Real Estate and Urban Economics Association.

Illiquidity and Pricing Biases in the Real Estate Market

This paper addresses the micro-analytic foundations of illiquidity and price dynamics in the realestate market by integrating modern portfolio theory with models describing the real estate transactionprocess. Based on the notion that real estate is a heterogeneous good that is traded in decentralized marketsand that transactions in these markets are often characterized by costly searches, we argue that the mostimportant aspects defining real estate illiquidity in both residential and commercial markets are the timerequired for sale and the uncertainty of the marketing period. These aspects provide two sources of bias inthe commonly adopted methods of real estate valuation, which are based solely on the prices of soldproperties and implicitly assume immediate execution. We demonstrate that estimated returns must bebiased upward and risks downward. These biases can be significant, especially when the marketing periodis highly uncertain relative to the holding period. We find also that real estate risk is closely related to investors time horizons, specifically that real estate risk decreases when the holding period increases.These results are consistent with the conventional wisdom that real estate is more favorable to long-terminvestors than to short-term investors. They also provide a theoretical foundation for the recent econometricliterature (e.g., Gatzlaff and Haurin (1997, 1998), Fisher, Gatzlaff, Geltner, and Haurin (2003), andGoetzmann and Peng (2003)) which finds evidence of smoothing of real estate returns. Our findings helpexplain the apparent risk-premium puzzle in real estate -- i.e., that ex-post returns appear too high, giventheir apparent low volatility - and can lead to the formal derivation of adjustments that can define realestates proper role in the mixed-asset portfolio

Commercial Mortgage Defaults: Proportional Hazards Estimation Using Individual Loan Histories

This paper examines the theory of commercial mortgage default and tests it using a data set of 2,899 loan histories provided by a major multi-line insurance company. A default model is estimated which relates subsequent default incidence and timing to contemporaneous loan term, borrower, property and economic/market conditions. Maximum likelihood estimation is used to estimate a hazard function predicting conditional probability of default over time. Results confirm many expected default relationships, in particular the dominance of loan terms and property value trends over time in affecting default. The effectiveness of the model in discriminating between good and bad loans is explored. Implications for underwriting practice and credit risk diversification are noted. Finally, suggestions are made for extending these results in pricing applications. Copyright American Real Estate and Urban Economics Association.

Predicting Commercial Mortgage Foreclosure Experience

This study has two objectives: (1) it directly evaluates the relationship between commercial mortgage default incidence and characteristics of the mortgage, borrower, property, market, and general economic conditions, and (2) it uses this relationship to predict the exposure of life insurers to future mortgage defaults and to examine the relative importance of various causes of current and past credit quality problems. A theoretical model of the default decision predicts that the decision would be expected to be driven primarily by the borrowers current equity stake in the property, or the ratio of the market value of the loan to property value (M t /V t ), but that the presence and magnitude of transaction costs associated with default would be expected to result in underexercise of the default option. Empirical estimation making use of American Council of Life Insurance (ACLI) and National Council of Real Estate Investment Fiduciaries (NCREIF) data confirms both expectations. A high proportion of the longitudinal variation in foreclosure incidence is explained by variations in M t /V t , but even at high ratios M t /V t in excess of 1.1. only 5% to 8% of mortgagors default, although this magnitude of underexercise is probably overstated because of problems in measuring M-super-t and for other reasons. Simulations using the model provide a pessimistic outlook for future defaults. Default rates are predicted to double in the five-year period 1988-93. Other simulations examine the relative importance of interest rate fluctuations, property value declines, and geographic or temporal correlations in lending during the 1976-88 period on current default experience. Copyright American Real Estate and Urban Economics Association.

Does the low-income housing tax credit increase the supply of housing?

Abstract The low-income housing tax credit (LIHTC) was originated in conjunction with the Tax Reform Act of 1986 (TRA 86) to provide incentives for private sector production of low-income housing. In this note we examine whether these units have added to the existing stock or merely substituted for unsubsidized units that otherwise would have been built. We explicitly control for effects of the number of other supply-side (e.g., public housing, Section 8 New Construction, Section 236 housing) and demand-side (vouchers and Section 8 Certificates) subsidies. From estimations of a simple cross-state model of the determinants of the stock of housing per 1000 population, we find no significant relationship between the number of LIHTC units (and other subsidized units) built in a given state and the size of the current housing stock, suggesting a high rate of substitution. However, our test is not sufficiently powerful to reject some alternative null hypotheses that suggest a lower rate of substitution, and we make some suggestions for future research.

Handing Over the Keys: A Perspective on Mortgage Default Research

This paper is the text of the 1992 Presidential Address for the American Real Estate and Urban Economics Association. A comparative evaluation of mortgage default research finds that both the residential and commercial markets evolved from informal underwriting rules, to formalized (though unvalidated) ratios and rules of thumb, to early risk ratings based upon empirical evidence, to gener-alizable econometric models of default, to option-based pricing models. The commercial market lagged the residential market by about 10 to 20 years at first but is now only about five years behind. The survey finds that research and progress in understanding mortgage credit risk has been precipitated by a public policy need or mandate, data availability, and adequate technology. The absence of any one of these factors has hindered progress in the past. Finally, six emerging issues in default research are identified and discussed: (1) the degree of ruth-lessness with which default is exercised, (2) loan recourse, (3) the magnitude and timing of revenues and losses associated with default, (4) loan modification, (5) default in a portfolio context, and (6) leasehold default. Progress in these areas will enhance the efficiency of both the residential and commercial markets. Copyright American Real Estate and Urban Economics Association.

Optimal Comparable Selection and Weighting in Real Property Valuation

This paper formalizes certain aspects of the sales comparison approach to valuation that heretofore have been quite ad hoc. Specifically, it applies statistical theory to decisions about how many comparables to select, what the criteria for comparable selection should be, and how the proper weights for each adjusted value estimate can be determined such that the final value estimate is both unbiased and of minimum variance. Several results are derived that run counter to conventional practice; for example, it may not always be optimal to consider first the best comparables because of a lack of independence among their adjusted value estimates. Furthermore, it is always desirable to consider more comparables (regardless of how bad) so long as their adjusted value estimates are optimally weighted in the final value estimate. Finally, weights usually selected for inferior comparables are typically too small. A final exercise empirically applies the methodology to a sample of sales. Copyright American Real Estate and Urban Economics Association.

Giving households credit: How changes in the U.S. tax code could promote homeownership

Abstract Recent U.S. government proposals intend to increase the homeownership rate by roughly 2.5 percentage points, to 67.5%, by the year 2000. The possible use of the U.S. income tax code is virtually ignored in these proposals. Using a user-cost framework incorporated into a tenure choice equation and both macro- and micro-level analyses, we demonstrate that the revenue-neutral replacement of the current deductibility of home mortgage interest and property taxes with a tax credit of the appropriate level alone can increase aggregate homeownership rates in the range of 3 to 5%. Moreover, these increases are even higher in lower-income neighborhoods, suggesting that such a policy could address the supplementary community development purpose of neighborhood stabilization.

FHA restructuring proposals: Alternatives and implications

Abstract This article evaluates problems of the Federal Housing Administration (FHA) under its current structure, develops criteria for judging alternative structures, and suggests one alternative—an assigned risk pool—that encourages efficiency in the insurance function while still promoting low‐ and moderate‐income housing. A historical introduction explains how the current institutional relationships came about and created FHAs problems. FHAs decline resulted from the mixing of a heavy social agenda with the basic insurance objective, a destructive reorganization of the Department of Housing and Urban Development that caused FHA to lose control and focus, and governments inherent inability to respond to market signals. Yet the economic rationale for government involvement in FHA functions is strong. An FHA organized as an independent government agency, a government‐sponsored enterprise, or even a privatized entity structured as an assigned risk pool could improve efficiency of underwriting, pricing,...