Mortgage Refinances, Streamlines and Adverse Selection

Abstract

The call and default options of mortgage borrowers interact in ways that must be accounted for in both the pricing of mortgages (or equivalently the setting of mortgage coupon rates relative to Treasury coupons), the pricing of default insurance, and empirical explanations of mortgage terminations. The call option of FHA borrowers was considerably enhanced in the early 1980s with a significant reduction in the cost of streamline refinancing (limited documentation, no required appraisal, etc.). This enhancement reduced the value of the default option of FHA borrowers. We provide evidence of the negative impact of regular (nonstreamline) refinancing on the average quality of FHA?s surviving business. We demonstrate this adverse selection both informally and econometrically. We also argue that FHA?s streamline refinance program has likely reduced the level of adverse selection in the FHA portfolio and provide quantitative estimates of the potential gain from this reduction.