Morgan J. Rose

Geographic Variation in Subprime Loan Features, Foreclosures, and Prepayments

Using data on subprime mortgages from ten cities, I examine geographic variation in the effects of prepayment penalties, balloon loans, and reduced documentation on the probabilities of foreclosure and prepayment. Results indicate that across cities, reduced documentation is consistently related to higher probabilities of foreclosure, and prepayment penalties are consistently related to lower probabilities of prepayment. Prepayment penalties and balloon loans are more sporadically associated with foreclosures, and reduced documentation and balloon loans are more sporadically associated with prepayments. These results are robust to controls for several state antipredatory lending law provisions, whose effects are also tested.

Origination Channel, Prepayment Penalties and Default

This paper presents evidence that non-bank-originated subprime mortgages have a higher probability of default than bank-originated subprime mortgages, but only for loans with prepayment penalties. Evidence also indicates that non-banks price prepayment penalties less favorably to borrowers than banks do, and non-banks originate disproportionately more loans with prepayment penalties in locales with less financially sophisticated borrowers. State anti-predatory lending law provisions restricting the use of prepayment penalties eliminate the elevated default risk of non-bank originations relative to bank originations. These findings are consistent with incentives generated by non-bank compensation via yield spread premiums on loans with prepayment penalties.

Loan loss reserves, accounting constraints, and bank ownership structure

This paper examines how the tightening of accounting constraints associated with the SunTrust bank decision in 1998 impacted the loan loss reserve policies of banks differently based on ownership structure. The SunTrust case, the result of an SEC inquiry over possible overstating of loan loss reserves, represented a strengthening of accounting priorities, which stress the importance of the reserve account for financial statement objectivity and comparability, relative to supervisory priorities, which emphasize the role of reserves for bank solvency through changing economic environments. The evidence presented indicates that publicly held banks, which fall directly under the SECs purview, reduced their loan loss reserve and provisions relative to privately held banks. Evidence also indicates that the positive relationship between bank earnings and provisions weakened, consistent with a reduction in either earnings management or early recognition of losses.

Prepayment Penalties: Efficiency and Predation

This paper presents evidence that reductions in mortgage interest rates associated with prepayment penalties are greater for riskier borrowers, as measured by mortgage type, credit scores, and local incomes and education levels. This is consistent with an efficiency view arguing that, by reducing the reclassification risk faced by lenders, prepayment penalties can be welfare-improving. Additional findings indicate that prepayment penalties are also used as a predatory lending tool, but the efficiency view dominates the predatory view in most circumstances. State anti-predatory lending laws restricting the duration and amount of prepayment penalties appear to curb the predatory use of prepayment penalties.

Golden Parachutes, Takeover Incentive, and Risk-Taking

We examine the relations between golden parachutes (GPs), pay-performance sensitivity (delta), and managerial risk-taking. We find an insignificant effect of GPs, but a negative and significant interaction of GPs with delta, on risk-taking. These results are consistent with the “takeover incentive hypothesis,” an original proposition stating that GPs influence risk-taking through the incentive of a CEO with a GP to accept a takeover, as well as delta’s role in affecting the weight of the CEO’s incentive to maximize the expected takeover-associated equity portfolio wealth. The findings do not support the proposition that GPs influence risk-taking through an insurance effect.