Failed or Failing Lending Institutions Behavior and Implications for the Pricing of Mortgages.

Abstract

As of 1989 more than one-fifth of the nation's federally insured saving and loans institutions have negative net worth. Very little is known, however, about their pricing behavior of financial assets. Most of the existing literature has focused on whether insolvent institutions bid up their cost of funds. The asset pricing issue of insolvent institutions has not been examined in the mortgage literature. This dissertation extends the literature by examining whether failed or failing saving and loan institutions offer their conventional fixed- and adjustable-rate mortgages at a discount relative to solvent institutions. A theoretical argument for the underpricing proposition is presented based on the premises that insolvent lending institution use the conditional repayment probability and do not consider capital losses due to an adverse shift in interest rates in setting credit rates. Therefore, insolvent lending institutions will tend to offer lower contractual interest rates on mortgages than well-capitalized institutions. Using a national data set three empirical tests are performed: a Chow test, a Goldfeld and Quandt test, and the Tishler and Zang maximum likelihood optimization technique. The results show that failed or failing saving and loans institutions do, indeed, offer their conventional fixed- and adjustable-rate mortgages at a discount relative to healthy lending institutions.