Household mobility, asymmetric information, and the pricing of mortgage contract rates

This paper characterizes how equilibrium rates on fixed and adjustable rate mortgages (FRMs and ARMs) are affected when borrowers and lenders have asymmetric information with respect to how long borrowers reside in their home. With an upward-sloping yield curve and competitive markets, lenders are shown to charge higher FRM rates in regions where borrowers are less mobile, even in the absence of traditional borrower refinance (prepayment) options. Further, for a given equilibrium FRM rate, FRM borrowers that move frequently effectively subsidize the mortgage costs of less mobile households. When ARMs are introduced, adverse selection causes some relatively mobile and less risk-averse borrowers to switch to ARMs forcing the FRM rate up as the pool of FRM borrowers becomes less mobile. Comparative static results further suggest that FRM rates are increased by a decline in borrower risk aversion and a decline in uncertainty about future ARM rates. Our theory is tested using a panel data set constructed from the Federal Home Loan Bank Board Survey of Mortgage Lending. Results from various specifications of the model support the hypothesis that market FRM rates are higher in regions characterized by less mobile borrowers, although the statistical significance of the estimated mobility effect is somewhat low by conventional standards. These results are consistent with anecdotal evidence that some but not all secondary traders of mortgage pools have begun to account for interregional differences in borrower mobility. Moreover, as additional mortgage traders become more sophisticated in their use of available information, the comparative static results derived here may become more pronounced.