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Idiosyncratic risk assessment in the mortgage market

Yanotti, MB 2015 , 'Idiosyncratic risk assessment in the mortgage market', PhD thesis, University of Tasmania.

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This thesis investigates the role of borrower characteristics in revealing risk assessment
in the mortgage market. Two innovations make important contributions to the international
literature. First, the thesis exploits a unique, detailed mortgage application
database which provides a means by which to investigate the role of individual characteristic
and personal circumstances in the variety of mortgage contracts found in the
market. Second, it takes advantage of the distinctive characteristics of Australian financial markets to analyze contract choice in an environment where, due to the relative
underdevelopment of a mortgage securitisation market and absence of government guarantees,
the risks of the mortgage contract are spread mainly between the originator (the
bank) and the mortgagee (the household).
As a result of the impact and spread of the global financial crisis of 2008-09, governments
and regulators are focusing their attention on macroprudential policy and systemic risk.
Results presented in this thesis demonstrate that underpinning these macroeconomic
concerns are important issues for the understanding of idiosyncratic mortgage risk. We
focus on these micro level problems by studying loan-level owner-occupier mortgage application
data. This work reinforces the relevance of assessing and pricing the risk for
borrowers and lenders based on the personal characteristics of the individual household.
In particular, the thesis investigates the role of borrower characteristics in the determination
of: (i) mortgage product choice; (ii) loan-to-value ratios; and (iii) mortgage
interest rate.
The thesis brings together three substantive essays which are intended to be published
as separate papers, accompanied by two chapters which provide background to the Australian
financial sector (and the role of mortgage markets) and details on the micro
loan-level application data on which the subsequent empirical work is based. The first
essay aims to provide a formal clarification of the association between borrower characteristics
and types of mortgages by building typologies of borrowers based on their
characteristics and the type of mortgage they take. It introduces the use of Multiple
Correspondence Analysis techniques to household finance data. The empirical work finds
that young, low-income and low-wealth applicants deviate from the mean borrower, and
that households with high income but low wealth are associated with variable- or fixed rate
mortgages, while households with low income but high wealth are associated with
home equity loans and discounted variable-rate mortgages. However, borrowers remain
heterogenous within mortgage types. Fixed-rate mortgages are taken by young, constrained
families, settled families and mobile first-time buyers. Discounted variable-rate mortgages are taken by young (female) households, settled families and mobile first-time buyers.
The second essay considers the empirical evidence on mortgage product choice with the
inclusion of a full range of variables representing mortgage costs, market conditions and
borrower characteristics, consistent with models proposed in the theoretical literature.
A discrete choice model is used to predict the marginal effect of borrower characteristics
on the probability of choosing a particular mortgage product. Moreover, it explores the
way mortgage choice effects are affected by loan-to-value ratio incentives given to banks
and imposed by the Australian regulatory body - in accordance with the Basel capital
requirements. It reveals a relationship between the prudential regulatory structures and
the mortgage choice at an individual-level. It finds that, contrary to popular wisdom, the
Basel capital adequacy rules play a 'sorting' role in terms of the types of loan contracts
that emerge from the interaction between banks and borrowers. Although mortgage
choice is mainly determined by the relative cost of the mortgage and by a broad range
of borrower characteristics - which reveal life-cycle stage, income and wealth constraints
and uncertainty, risk-aversion, financial experience, and mobility expectations - these
borrower characteristics play different roles for different loan-to-value ratio levels.
The third essay addresses possible endogeneity and bias selection in estimating mortgage
choice. Endogeneity is addressed by predicting the loan-to-value ratio and instrumenting
the value of the property under the mortgage contract. Selection bias, which arises
from observing only the revealed preference of the borrower and not the alternatives in
the choice, is corrected by estimating the reduced form of the interest rate associated
with the mortgage. This chapter focuses on the effect borrower characteristics have
on interest rate and loan-to-value ratio determination. It finds that the value of the
property at the time of application is not statistically significant in determining the
loan-to-value ratio the bank offers to the borrower; however house price in
ation and expectations determine the loan-to-value ratio. Moreover, income and wealth levels
are strong factors determining both loan-to-value ratios and individual interest rates.
Importantly, borrower characteristics play the role predicted by theory in defining price
and terms of the mortgage at the individual level. This finding is necessary, but not
suffcient, for market effciency.

Item Type: Thesis - PhD
Authors/Creators:Yanotti, MB
Keywords: Mortgage, household finance, housing finance, idiosyncratic risk, Australian mortgage market
Copyright Holders: The Author
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Copyright 2015 the author

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