Does the presence of a cluster of subprime mortgages in a neighborhood lead to a greater likelihood of foreclosure in that neighborhood among other non-subprime borrowers? This question must be on the minds of many. If you live in a neighborhood with a significant number of subprime loans, you are most certainly wondering if the presence of these loans will increase the likelihood that your property will be foreclosed upon. If you are a lender with a portfolio of loans that are in close proximity to subprime borrowers, you are most probably speculating on their impact on the chance that their presence will lead to foreclosures on your loans. If you are a politician and you supported the expansion of credit to less than perfectly qualified borrower in the interest of expanding home ownership, you are most certainly interested in the answer to this question.
The worry is that too many foreclosures caused by the presence of subprime borrowers will lead to lower neighborhood prices resulting in otherwise healthy loans going “under water” and resulting in their eventual foreclosure. This seems like such a critical question. You have to wonder why no one has attempted to answer it. Well someone has but few know about it.
Specifically, Agarwal et al [i], in a forthcoming paper in Real Estate Economics, address this very question. In fact, they find that the presence of a cluster of subprime loans does not increase the chance that other neighborhood properties will fall into foreclosure. They do, however, find that the local presence of a cluster of the most aggressive hybrid ARM products and low/no-doc loans (a subclass of subprime loans) does increase the likelihood that other nearby properties will fall into foreclosure.
The mere presence of nearby subprime loans does not in itself appear to impact the chance of foreclosure. However, a clustering of interest-only ARMs and low/no-doc loans does increase everyone’s chances of falling into foreclosure. This is most likely occurring because prices in these latter neighborhoods are not holding up in the face of nearby foreclosures. So, the results appear to be mixed. While most can breathe a sigh of relief, those that: (a) live in neighborhoods heavily populated with hybrid ARMs and low/no-doc loans, (b) hold loans in these same neighborhoods, and (c) politicians that supported the availability of these wildly unconventional loans have to worry about the fallout. Clearly, the first two groups face the potential of future financial loss; however, it remains unclear how politicians who supported “a house for everyone” will have to ante up.
[i] Agarwal, S., B.W. Ambrose, S. Chomsisengphet, and Anthony B. Sanders. Thy Neighbor’s Mortgage: Does Living in a Subprime Neighborhood Affect One’s Probability of Default? Forthcoming in Real Estate Economics.
© Copyright Ken H. Johnson. This material may be freely duplicated and republished under the following conditions: (a) the author’s name must be clearly visible; (b) the author’s journal affiliation must be clearly visible; and (c) the author’s university affiliation must be clearly visible. Otherwise, this material may not be reproduced in any form without the written consent of the author.