Essays on Behavior of Mortgage Borrowers

Most financial theories are developed based on assumptions of market efficiency and consumers' rational behavior. Rational choice theory postulates that consumers, when given multiple choices, will choose the best and optimal option based on their own set of preferences and constraints. However, in the real world, we rarely, if ever, observe the full set of preferences and/or constraints, which sometimes make decisions appear contradictory, or even irrational. This dissertation is about studying the choices that were made by individual mortgage market players and evaluating these choices against the theoretical foundation of financial theory. The first essay, "Option ARMs: a rational choice or an act of desperation?" focuses on a unique mortgage product -- Option ARM -- that is perhaps the most complicated mortgage contract that exists in the U.S. residential mortgage market. Despite claims made by some politicians and news media about predatory nature of Option ARMs, we find that Option ARM can be beneficial to borrowers with high income volatility or borrowers with limited savings but strong income growth potential. We propose a range of proxies to test rationality of borrowers' decisions. Results show we cannot disprove that borrowers behaved rationally. In addition, our results suggest that the "housing fever" that hit U.S. in mid-2000s played a role in making housing less affordable and pushing some consumers, who wanted to increase their exposure to housing market, to apply for Option ARM loans in order to qualify for a mortgage. The second essay, "The effect of mortgage brokers on pricing and performance of loans: evidence from large non-subprime lender," studies the relationship between mortgage brokers and mortgage lenders and their respective rationales for focusing on originating Option ARM loans. We provide evidence suggesting that the lender in our study had overly optimistic expectations about future direction of home price growth. This high price expectation led to mispricing of the risk of Option ARM loans, and, consequently, to unbalanced broker compensation structure. We also provide evidence of mortgage brokers taking advantage of that mispricing by steering borrowers towards riskier products (Option ARMs). The focus of the third essay, "Unobserved heterogeneity and its effect on mortgage options", is to study the two key features of a modern mortgage contract: borrowers' ability to terminate the mortgage through default or through prepayment. Despite wide acceptance of the options-based theory, borrowers' exercise of the two options in real life often fails to follow theoretical predictions. The research focuses on the origins of this seemingly irrational borrowers' behavior of mortgage options exercising. We extend previous results by studying how the relationship between unobserved heterogeneity parameters changes while using an expanded list of borrower- and mortgage-related covariates. The results show that unobserved heterogeneity is reduced by 33% after including both additional asymmetric information from the time of origination as well as time-varying loan-level information. The research also advances our understanding about distributional assumptions on unobservable heterogeneity parameters when modeling a diverse population of mortgage holders.