Tuesday, December 28, 2010

New Regs Hurt the Poor

The Inefficiency of Refinancing: Why Prepayment Penalties Are Good for Risky Borrowers

Christopher Mayer, Tomasz Piskorski & Alexei Tchistyi
NBER Working Paper, December 2010

Abstract: This paper explores the practice of mortgage refinancing in a dynamic
competitive lending model with risky borrowers and costly default. We show that prepayment penalties improve welfare by ensuring longer-term lending contracts, which prevents the mortgage pools from becoming disproportionately composed of the riskiest borrowers over time. Mortgages with prepayment penalties allow lenders to lower mortgage rates and extend credit to the least creditworthy, with the largest benefits going to the riskiest borrowers, who have the most incentive to refinance in response to positive credit shocks. Empirical evidence from more than 21,000 non-agency securitized fixed rate mortgages is consistent with the key predictions of
our model. Our results suggest that regulations banning refinancing penalties might have the unintended consequence of restricting access to credit and raising rates for the least creditworthy borrowers.

It has been the maintained hypothesis here at KPC for some time that the PRIMARY burden of the new nanny regs on financial markets will be poor or risky borrowers. It's actually pretty obvious, when you think of it.

(Nod to Kevin Lewis)


Shawn said...

[a prepayment penalty] "prevents the mortgage pools from becoming disproportionately composed of the riskiest borrowers over time."

can't believe I never considered that. great point.

Shawn said...

though, haven't we learned that mortgage pools don't work? at least, as they're currently designed, calculating risk is pretty much impossible.

Anonymous said...

"calculating risk is pretty much impossible"...so then is the whole field of actuarial science irrelevant? The actuaries of the world, who by the way are smarter than just about anybody, might disagree.

Shawn said...

In mortgage pools, anon, it appears to have not worked very well.