The effects of mortgage laws on home mortgage rates

‘lithe Effects of MortgageLawson HomeMortgageRates Mark Meador

OF REGIONAL MORTGAGE RATES

DEIIXMINAN~

Mortgagerates are typically lowest in the Northwest and the Midwest and highest in the South and West.’ The pattern suggests that ditferentials reflect finite interregional mortgage supply elasticities Rapidly growing regions have higher mortgage rates because of greater regional mortgage demand relative to regional mortgage supply.’ but the interregional comparison of home mortgage rates is complicated by the heterogeneity of home mCartgages.The contractual rights of borrowers and lenders vary by region, as do loan-to-value ratios, maturities, and borrower characteristics. Even if in:erregional supply elasticities were perfectly elastic, there is no reason to expect equal rates across regions. This study deals first with heterogeneous mortgages. Then regional import or export of mortgage funds is introduced to control for differences due to inelasticities in the movement of funds between regions. Beginning with the early credit rationing literature (Hodgman 1960; Freimer and Gordon 1965), economists began to incorporate heterogeneity into formal modelsof loan contracts.Recently, Benjamin (1975) and Rarro (1976) developed loan contracts models with theoreticallyexplicit predictionsconcerning the effkctcthat dflerences in loan-to-value ratios and foreclosure and delinquency costs have on mortgage rates. The spirit of the loan contract models i This stdy ewmi~~~~marlrates in 18 cities from 1973 to 1976. -l&c knvcr hnlf of the sam~k inchxkd Boeton. New Yodt. B&nom. St. Louis. Mhmupoiis. Philuklphi4, Chicago, ikveland. and Deaoit. In the upper half wem Allmu. Denver. Lw Angcks, Wnshingta~. DC.. Ddlu. Mi. Houston. Sank. and San FmnciaM.

A&~KSSreprintrequeststo Dr. MarkMeador.OfFw of Eblicyand &iummic Rd. Fukral Honw ban Bad Board. Wpshi. D.C. 20552. .... JoumalofEconmuksa~~IBusiwss 34,143-w (1982) @ 1982 Temple Univasity

can be brie3y summarized. A loan is made on a home that has a stochastic future value. At each payment period the borrower has the option of continuing payment or defaulting on the loan and losing the collateral. The borrower faces a recurr& implicit purchase decision of either “buying” the home at the present value of the remaining payments or defaulting on the mortgage. The further the market price of the home falls below the present value of the remaining debt, the greater the likelihood the borrower will not exercise the option of purchasingthe home for the outstanding debt. With a larger initial loan-to-value ratio the probability that the future value of the home will fall below the debt value and default will occur rises. Since the defaulted property has a lower value than the remaining debt, the lender’s expected return de&es as the loan-to-value ratio and default prob ability rises. A higher mortgage interest rate is required to equilibrate the expected rate of return on high loan-to-value mortgages with low loan-to-value mortgages. The maturity of the contract has similar effects. Lengthening the maturity of the mortgage will lower the rate of equity accumulation and increase that probability of negative equity in the future. The higher probability of default will require a higher mortgage rate, but lengthening the mntract will also reduce monthly payments. Some observers have argued that lower monthly payments will decrease the risk that the borrower cannot meet the payments..’ If so. increasing maturity will have an

M. Meador

144 ambiguous net e&cl on lender risk and mortgage rates. lf default occurs, the lender faces the costs of reconciirng the default or pursuing foreclosure and sale of the property. These costs are directly related to state mortgage laws. There are substantial interregional differentials in the rights of borrowers and lenders in the event of default and foreclosure. Many states allow the deed of trust, and foreclosuresare handled by a trustee who has the power of sale. The deed of trust involves three parties: trustor (borrower), trustee. and beneficiary(lender). To borrow money for a home purchase.the tristor issuesa promissory note to the beneficiary,and the title to the property is held by a trusta:. The trustor can sell or conduct any typical prowrty owner action that is not inconsistent with the rights of the beneficiary. !.r the promissory note is not paid. the beneficiary can request that the trustee sell the property to satisfy the defaulted obligation. 3~ u usteecan conduct a foreclosuresale, convey the titk- IO the purchaser, and turn over the proceeds to the beneficiary. In states that require a judicial foreclosure.the title to the property is held by the borrower There is no third-party trustee or power of sale.Wl~n a borrower defaults.the lender mus: file a lawsuit against the debtor before a foreclosure sale can be made. The validity of the promissory note and proof of default must be established in court. If WCC;...ful, the court will decree that a courtnppointed commissioner conduct a foreclosure sale. f~oreclosure is a more difficalt and expensive process when these judicial procedures are required.

Regardlessof whether the foreclosureis handled in court or by a trustee, the foreclos re process is timeconsuming The time required depends on state statutes and procedures. The costs to the lender in terms of foregone payments or rents increasewith the time to complete a foreclosuresale. In a few statesthe borrower continuev .-:;retain possession rights to the property after rhe sale. and during this redemption period the lender receives no income propert)

from

the

The final important difference among state foreclosure laws ia the deficiency judgment. If the sale value of the hclme falls shw

of the contractual debt,

few states give ;he lender the ri&t

to pursue the

--~_uslng a sample of saving5 ald loan tsw&uions. McEumne awl Cramer( I975) foundrbafsipificzuu cosl diffettntids were associared wilh slate forecb5urelaw. MCI% and Cramer used cost accounfing data to davmau hreclosurp eapcnscs at savingsamI loan ;zs~m. TIE ;pmed paper differs by focusingon the effects ol forecbsure law on mortgage riuts and using eronomeuic analysis. l

ditTerencein court. With no deficiencyjudgment. the borrower has no potential liability after the foreclosure sale. The borrower has a put option and is more likely to default. The absence of a deficiency judgment option reducesthe lender’s expectedreturn from a foreclosure action. Mortgage rates are a&ted by the lender’s cost of funds. The n>st of mortgage lending includes both a national and a regional component. If the national level of interest rates rises.all regional mortgage rates must rise to compete with alternative debt instruments. The cost of funds may also have a regional component due to regional imprts of capital. If the interregional supply of funds is less than perfectly elastic, regions with relatively large capital account deficits must pay a premium to import mortgage funds. The past few decadeshave witnessed considerable interregional movement of mortgage funds The Frimary mechanism for the interregional movement of funds is the sale of mortgages or participation interests in pools of mortgages. Mortgage companies originiate and then sell 15 to 20 percent of all residential mortgages. Over 10 percent of mortgages closed by savings and loan associations are sold.5 Federal or federally sponsoredagencieshave become increasingly involved in the intcrregional guarantee and purchase of mortgages. In particular, the Government National Mortgage Association (GNMA), the Federal Home Loan Mortgage Corporation (FHLMC) lu;d the Federal National Mortgage Association (FNV introduced and expanded several programs to aid secondary mortgage markets.6 Thr interregional mortgage market does not necessarilyio:$y that interregional supply elasticities are perfectly elastic. If supply elast*:ities are finite. the incremental costs of out-of-regica funds relative to local funds must be covered. Greater dependenceon o&J+-of-regionfinancing will lead to higher regional mortgage rates. To allow for the possibility of finite supply elasticities, the net regional import of mortgage funds will be added to the equations explaining regional mortgage rates. If there are significant COW associated with the interregional transfer of mortgages,there is a related issue to examine. i%e data

5 ivZortgagecompany data were obtakd fromvariousissuesof (MortgageBa&rs Association of America).Data for savingsawi loanassociations WCRgtilrcd from(MottgageBankersAssaciation of America). * Fora dtscriptiooof lbeguarantee andpurchase progr4m.s made availableby GNMA. FHLMC and FNMA. see U.S. Leagueof SavingsAssociations ( 1976).

Mortgage Laws ml Interest Rateson Mortgages

used in this paper cover a four-year period when the GNMA, FHLMC. and FbiMA. programs were growing rapidly in size and availability. These programs,combined with general market improvements, may have f&ted the interrcgionai trtmdkr of mortw funds increasing intcrrcgional supply elasticities and reducing interregional rate difkrcntials on similar mortgages Usury ceilinga impose several distortions on mortgage contracts and interregional mortgage flows Ceilings restrict the range of amtracts lenders can prditably offer. Ostas (1976) and Crafton (1980) have shown that binding ceilings lead to lower loan-tovalue ratios and maturities Smith (1977l has shown a reduction in the proportion of low income borrowers Robins (19741, Ostas (1976) and Crafton (1980) presentedevidence that ceilings inhibit regional housingconstruction. In the interreg$onalmarket, bilding ceilings will discourage the regicnal import of funds and encourage purchases of mortgages from uncontrolled areas Unfortunately for the estimation of regional mortgage rate determinants, there are numerous unreported margins at which mortgage funds can bc rationed. Available interregional data are insuflicienr to model adequately and estimate all the distortions that usury ceilings impose on regional mortgage markets.’ The scope of this study is restricted to the etfects that regional mortgage characteristics, mortgage law. and imports of mortgage funds have on regional mortgage rates.To estimate these free of any usury distortions. equations will be estimated only with observations unconstrained by usury ceilings. The primary data source for this study is the Federal Home Loan Bank Board’s monthly survey of conventional home mortgages on new and existing homes from 1973 through 1976. During this period. the FHLBB compiled average effective mortgage rates (including fees),loan-to-value ratios, and maturities for I8 SMSAs. In the following discussion effectiverates are experessedin basis points (iU.O@, = IO00 basis points). The loan-to-value ratios are expressed as percentage points of value. Maturities arc measured in years. The costs associated with default and foreclosure arc represen!ed by state laws. A dummy variable is included to distinguish states that require judicial ~-

.-

’ TO don -ages at the usuryceiling, the knaer can squire molestabkinComes, longer waiting periods, ad bonus in wellestablished neighbohoods. Lenders’ employees may get special treatrrhznt.or borrowers may hsvc to make substantii3l depositswith lenders. Avaihbk intemgiohsl data simply do not provide informationonmanycfthemspomestotheusmyniliig.

148

foreclosure horn those that allow the power of sale. The variable is I of the state requires judicial fo~tosure and 0 Otherwise. Since judicial foreclosur: is more expensive_the coe&ient is expected to be positive To indicate the foreclosureperiod, a second foreclosure variable is defiutedas the period between notice of defauit and foreclosure sale plus any additional pe%d in which the borrower can retain pcrssessionof the property. The foreclosureperiod is measured in months, and its coe&ient is expected to be positive. A dummy variable indicates the lack of a potential defiicy judgment. The absence of a deGency judgment should lead to a positive coe&ient.a The national level of interest ratesis represen!edby the Fedd Reserve Bulletin yield on long-term government bonds.’ The FHLBBS trortgage data are based on mortgages closet! during the first live businessdays of the month. Becauseof lags between initial origination and final closing of a mortgage, the FHLBB data retlectcredit market conditions prior to the reported month. To represent the alternative rate for the period immediately prior to the reported month, the government bond rate is lagged one month. Data on interregiondl movements of mortgage funds from all lending sources are not available, but net savings and loan assbtiation mortgage sales are available on an SMSA basis. The data include the total amount of mortgages closed within the SMSA and the net sale of mortgages, total loans and participations sold le.% loans and participations purchased.” The net sales relative to the total amount of mortgages closed is the proportion of savings and loan mortgage activity financed externally. The proportion illustrates theextent to which the largest group of home mortgage lenders rely on external financing and in this study representsthe net regional imprt of mortgage funds. If interregional supply elasticities are les- than p&ctly elastic. greater regional imports ~111lead to higher regional

’ All infornation on foreclosurelaws is obtainedfrom Sherman ( 1973-1976). Shnan’s guide is a privately ownedcnte@se that providesstatemmtgagelaw informationto intenegiondkndea. The eaistence of Shemun’s Pit-3 is an indication that difktentids in nwxtgage laws affect axts and are valuabk informdon for interIegiOMllcndc3s. 9* lonp-term govenunent bond rate cunformswith the theor&al nxxkls of hxm contractspresentedby Baltemperger( Iw6). Banu rlQ16), Benjsmin (1975). Frcimer and Gordon :r965). WKJ Hodgman (IA9). I0 Unpubhhed data an mo@aSe lo%3 pureha%’ ---2 sold and mmtgageloaluclosedbysavingsalKtlo&;W..Ic~i clEdltain4 from the FHLRB.

M. Meador

146 mortgage

rates. To investigate the possibility that

the regional variables have proportionately

greater

interregional costs of transferring mortgage funcls fell

effects on nominal mortgage rates when the level

during the I973-- 1976 period. regioa. l imports times

nominal

a time trend is added to the estimated equalions. A

logaritF,m of equation

sig&cantly

semilog specification:

negative coeflicient will indicate that

reigonal imports had a decreasing elTect on regional mortgage rates. The time trend is measured in months

In

interest

R,= a,+~,

rates rises. Taking

(I) results in the following

R,+a,M+aJ./Y+u4J

In

+u,F+a,D+a,l+a,PT.

beginning with January 1973.

of

the natural

(21

Potential usury distortions are avoided by eli?cinatmg observations that are constrained by binding

This specification is used for the regressions in the

usury celings. The FHLBB

follcwing section of the paper.lZ

reports that the typical

range of mortgage rates reported within an SMSA at any given time is from 75 to I25 basis points.’ I Mortgage rates arc distributed around the reporliLd

EMPIRICAL

RESULTS

average. Even if reported sverage mortgage rates are

AND DISCUSSION

below a usury celing. some mortgage rates may bc

Table

constrained by the ceiling. A plus or miuQs 75 basis

Separate regressions are computed

pomt band around the reported rate incorporates the

new and existing homes, because new-home

typical distribution. If the reported rate is at leas* 75

frequently

basis points below any usury ceiling, there is I,ttle

months.14 Most

likelihood

that a ceiling is distorting

ihe regional

I contains the estimates of equation (2)‘“.

reflect commitments

fOir

mortgages on

made

rates

in earlier

of the estimated coellicients are

significant and have the expected signs. As in earlier

mortgage market. Any observation within ‘75 basis

studies (Shaaf

pomts of a ceiling is excluded from the estimate.l

significant and loan-to-value ratio has the anticipated

equations. The remaining observations reflect market

positive impact on mortgage rates.

1966; Ostas 1977). maturity

is in-

behavior in the absence of binding usury constraints.

Requiring a judicial foreclosure, lengthening the

The following functional form is used to estimate

foreclosure period and eliminating the possibility of a

the determinants of regional mo . “age rates.

delicienc 4judgment all make the foreclosure process more costly and raise mortgage rates. For example, with an initial mortgage rate of loo0 basis points, a judicial foreclosure requires an additional

mortgage

rate of I 1.09 basis points (existing homes) to 12.1 I

u here

basis points (new homes). Extending the foreclosure

R,=

eflective mortgage rate

period by three months raises the mortgage rate by

R,=

long-term government bond rate

4.75 basis points (new homes) or 10.04 basis points

51 =

maturity

(existing homes). Eliminating

L b.7:

loan-to-value

J=

Judicial foreclosure

f- =

foreclosure period

D >.

no delicienc! judgment.

I=

net import5

7-z

time trend.

ratio

(new homes) or 22.65 basis points (existing homes). If

states would allow sale by trustee, permit deliciency ----__ I2 Linear equations went also estimated. llu

With this function. the regional mortgage rate is proportional to the national level of interest rates cn

bxq+rm

debt

instruments.

The

proportion

wtll

depend in part on the regional variables M through I. The function allows these variables to have the same relatrve or real elTect on mortgage rates regardless k.)f the national level ofnominal

interest rates. Changes $n

” Ostas t 1976) rcpcn~ a IMbas~s point distribution. C&ion

I IWO!rcporha 75 to 12%pomtspread

the lender’s right to

pursue 1?deficiency judgment adds 13.87 basis points

linear teslduals implkd by the semi-logequationswere comparedwith thosefrom the linea equations. Neither specificationrevealed significantly better tits. Pkcauseof the u priori lcasonsdiscuti in the text. the semi-log estim,atesare pnsentcd. No qualitativeconclusioinrare affectedby the choic: of specification. I3 Ordinary least quares IS the esfi nation technique.Often with pool4 time-seriesdata the covarianceor least-squares with regionand periaii dummies model is employed. With the pnesentdata settheseis no inlemgional variation in the governmentbond rate and no intraregiotuutariation in motlgagelaw. In the contextof the covariance model the mortgagelaws are the regkmaleffectsandthe bondmtesatz the periodeffects. The mortgagelaws andbondfatescan be expressed as Imear combinationsof region and period dummies. The perfect mtilticollinearity prevents separate identification of the covariance models region and period dummy coeffkients. I* I am thanklid to the referee for this point.

Mortgage Laws and Interest Rateson Mortgages

TABLE 1. Regres-is;?! Results for Regional Mortgage Rates (Nh~ral Log in Basis Points) Regression Coefficients and Standard Errors New Homes Intercept InRb M L/V

Exist4

Homes

0.5792t (0.1359

0.1392 (0.1423)

o.9347b (0.02114) -0.001297 (0.301247) 0.001862b (0.0003423)

1.0156 (0.02 114) -0.O002866 (0.0004457) 0.0007775~ (O.OOO2929)

J

0.01204b (0.004808)

o.ollo3b (0.004171)

F

0.001577~ (0.0007878) 0.01377b (O.OO4151) 0.001934~ (0.0003770) -0.00002589* (0.000009980) 0.8076 0.03205

0.00333 lb (0.0007829)

D

I

PT

R2 SER

o.o224ob (0.003976) 0.0027216 (0.0003572) -0.0000471 lb (0.00001025) 0.8262 0.03 196

a Significant at 95% confidsnce level. * Significant at 99% confidence level.

147

CONCLUSIONS This stud) has examined interregional mortgagerates differentiais and the effects of mortgage ontract terms mcrtc:ge laws, and dependence on out-ofregion m%tgage funds. The potential mortgage market distortions imposed by usury ceilings were dealt with by excluding observations that had binding usury constraints. Interregional di&rentials in loanto-value ratios are significant determinants of rate differentials. but maturities arc not. Components of mortgage law represented by judicial foreclosure, foreclosure period, and deficiency judgment all had the expected effectson regional mortgage rates. Ttx results implied that significant costs are associatd with the mortgage laws.Considerable savingsin costs will accrue to borrowers if the foreclosure process is streamlined. increased regional import of mortgage funds increased regional mortgage rates, but this effect declined during the sample period.

I would like IO hank Charles Nelson, Dan Benjamin, and Levis Kochin for their comments on earlier stages of this research. I am also particularly grateful to an anonymous referee for several helpful comments and for substantial editorial assistance.Financial assistancewas provided by the Loyoia College Faculty ResearchFund and the Serttle Federal Home Loan Bank.

REFERENCES judgment, and shorten the foreclosure period. state mortgage borrowers could ohtain cumulative reductions in mortgage rates of 30.73 (new homes) to 43.78 (existing homes) basis points. In keeping with previous findings (Shaaf 1966, Ostas 1977), the resrllts demonstrate that regional mortgage markets are partially segmented. Throughout the period regions with greater net imports paid higher rates for similar mortgages. But the net import times time trend coeficient is negative and indicates that the net import of funds had a diminishing impact on regional mortgage rates. The negativecoeficient may imply that regional mortgage markets became more integrated during the sample period.’ 5

Baltensperger. Ernst. June 1976. The borrower-lender relationship: Competitive equilibrium, and the theoryof hedonic prices. American Economic Review 66:401405.

Batro. Robert G. Nov. 1976. ‘the loan market, collateral, and rates of interest. Journal of Money. Credit, and Banking 8:43%456.

Benjamin, Daniel K. 1975. Theory of collateral. unpublished Ph.D. dissertation, Los Angeles: University of California Press. Board of Governorsof the Federal ReserveSystem.Federal Reserve Bulletin. Washington, D.C., monthly. Crafton, Steven M. April 1980. An empirical test of the effects of usury laws. Journal of Law and Economics 23:135-b%.

Federal Home ban Bank Board. Federal Home Loan Bank Board Journal. Washington, D.C., monthly. Freimer. Marshall, andGordon, Mynn (3. Aug. 1%5. Why bankers ration credit. Quarterly Journal of Economics 79:397-410.

Is Some cautionshouklbe exercised before the negative PT coefficient is acceptedas evidencethatintemgioaal supplyelasticities increased.A singk equationwith relativelyfew explanatoryvariables has been estimated. SOmefactors that influence regional mortgage rates may have been left out of the equation. If these factors are corpeiatedwith the time trend, the estimatedPT coefficient will be biased.

Guttentag, Jack M., and Beck, Morris. 1970. NewSerieson Home Mortgage Yields Since 1951. New York: National Bureau of EconomicResearch. Hodgman. Donald R. May 1960. Credit risk and credit rationing. Quarterly Journalof Economics74:258-298. Longbrake, William A., and Peterson.Manfted 0. Regiotral and intrategional variations in mortgage loan rates. Journal of Economics and Business 3

’ ?5-83.

M.Meador McEihone. Jorrphine hi., and Gamer, Randall P. June 1975. The costs of mortgage loan foredosure: some scent findings. Federal Home Loan Bank BoardJournal

Smith, Halbelt C. Sept. 1964. Regional placement of mortgage funds by life insumnce companies. Jaarnal oj

8(6):7-12. Mortgage hnkers Association of America. Banker. Washington, D.C., montly.

Smith, Lawrence B. March 1977. An analysis of the effects of the removal of yield ceiling on federally inswd mortgages in Canada. Journal of Finance 32:195-201. Thygerson, Kenneth Sept. 1976. There is no such thiig as a national mortgage market. Savings llndkwi News. U.S. BureauoftheCensus. l97OCensrrsofffousing,Vol.S, Part I. U.S. League of Savings Associations. Mortgages for sale, buy if you can’t lend. Savings and Loan News. Wetmore, John April 1974. FHA and VA mortgages costs bargain in capital-short areas. Mortgage Bunker 34(7):5-

Mortguge

0s~. James R. June 1976. IEffectsof usury ceilings in the mortgage market. Journa~fof Finance 3 I :82 I-834. Cktas. James R. Dec. 1977. Regional differentials in mortgage financing costs: a reexamination. Journal of Finance 32:1774-1778.

Robins. Philip K. March 19’14. The efects of state usury ceilings on single family homebuilding. Journal of Finance 2!%22%235.

Schaaf. A. H. March 1966. Regiond differences in twtgage financing costs. Journal of Finance 2 1335-94. Shcma~~.MalcomC. 1973-1976. MurrgugeondRealEstare Invesrmenr Guide. 4Oth-48th eds. Marshfield, Mass.

Risk and Insurance 3 1~429-438.

16.

Accepted 24 November 1981