Thesis: Borrowers should think about their mortgages as contracts allocating risk, and realize that they expressly pay higher interest rates in exchange for the possibility that they may default on their mortgages.

• Mortgages are contracts
  • Banks agree to lend money to borrowers.
  • Borrowers agree to pay back loans plus interest.
  • Damages - if a borrower breaches the contract, the bank is allowed to take possession of the security.
• Allocations of risk
  • Lender’s risk:
    • If the borrower breaches the contract, the bank risks losing money. Whether the bank loses money depends on the remaining borrower obligations under the mortgage, the costs of foreclosure, the costs of resale, and the amount received upon resale.
  • Borrower’s risk:
    • If the borrower cannot or does not pay the mortgage and the bank is able to foreclose on the property, the borrower loses equity built in the home, if any.
• Banks assess risk differently for different borrowers, loans, and securities.
  • Different rates are charged to different borrowers - lenders realize that some borrowers are more likely to default.
    • FICO, credit history, occupation, DTI
  • Different rates are charged for different loans - lenders realize that borrowers are more likely to default on loans with certain characteristics.
    • LTV, 2nd Mortgages, ARM Schedule, loan size, Interest Only, loans for Non-owner occupied homes.
  • Different rates are charged for different homes - lenders realize that some homes are more or less likely to appreciate or depreciate in value, and that borrowers are therefore more or less likely to default.
    • Geographic location, type of home (SFR/Condo/3-4 Unit/Rural/etc.), accuracy of appraisal
  • Banks have the option of lending without risk, e.g. T-bonds, but they would get lower rates in exchange.
• Conclusion
  • Banks expressly consider how a given borrower, loan, and security affect the possibility of default; that affects the benefit required in exchange (i.e. the rate).
  • Borrowers pay more or less and banks receive more or less based on the bank’s assessment of these risks.
  • Where a borrower has an absolute obligation to pay, the bank is insulated from risk; the mortgage is a pre-defined security and income stream. That would mean borrowers pay additional rates and the banks receive additional rates without a corresponding exchange in the benefit/risk.
  • A borrower who chooses to default is exercising a right that was reserved in exchange for benefits given to the lender.

-- DanKarmel - 11 Jul 2010