IO Mortgages And The Housing Bubble

A comment I posted on "The means to speculate" on The Economist Free Exchange blog:

See "A Model of Mortgage Default" by Campbell and Cocco, November 2010,

http://kuznets.fas.harvard.edu/~campbell/papers/mortdefault24112010.pdf

for a discussion of mortgage defaults and IOs [Interest Only Mortgages] with a different perspective.

IOs are used by borrowing constrained borrowers because of lower required monthly payments. IOs do not amortize principal and have higher remaining balances later in their life than amortizing mortgages.

IOs have a lower default rate in their early years (lower required payments), but higher default rates in later years when there is negative equity because they have a higher remaining balance.

In a bubble, there are many speculators (whether they cause or follow bubbles is an open debate). Speculators try to use as much leverage as they can to buy assets. Speculators would tend toward IOs because they can borrow more. In currency and commodity markets, they would use futures and options.

As the economy tanked and home prices started to decline, IO users were the most borrowing constrained, which means the most income constrained, and they had the most negative equity because of the lack of amortization with higher remaining balances. Their borrowing constraint with high negative equity caused higher defaults. Plus, if they own multiple homes, as likely for speculators, a negative income shock to a single borrower will cause defaults on several homes and IOs. There is a multiplier default effect.

IO use was coincidental to the collapse of the housing market and defaults, not the cause of the bubble or subsequent collapse.

In speculative markets, speculators look for means to use as little of their own equity and as much leverage as they can. IOs were used to borrow more to purchase more homes with more leverage, but if they were not available, speculators would look for other ways to maximize their use of equity and borrow as much as possible.

The use of IOs just shows there were speculators in the housing market. It does not show causation for the speculation or the defaults. If you eliminate or restrict IOs, speculators will find some other means to increase their ability to speculate in a hot housing market.

Past IO use in a housing market showed there were speculators in that market. Eliminate IOs and you will not stop speculation in a hot housing market. Does speculation cause bubbles (Did speculation cause house prices to rise and then drop)? Valid arguments exist for yes and no.