art_10.1007_s11146-008-9151-1.docx

J Real Estate Finance Econ (2009) 38:214240 DOI 10.1007/s11146-008-9151-1 Mortgage Prepayment and Default Behavior with Embedded Forward Contract Risks in Chinas Housing Market Yongheng Deng & Peng Liu Published online: 26 September 2008 # Springer Science + Business Media, LLC 2008 Abstract Most condominiums in China are sold forward on a pre-sale market, where purchasers and developers transact on an underlying property that is not yet completed. During the pre-sale period home buyers face a significant forward contract risk. However, home buyers can borrow mortgages from banks so that they can effectively share the forward contract risk with banks. This explains the phenomenon of irregularly high early-stage default and prepayment rates observed in residential mortgage lending in China, where there are few, if any, financial incentives for mortgage borrowers to exercise either put or call options. Mortgages collateralized by forward housing assets are riskier than are those with underlying assets traded on the spot market. However, currently Chinese mortgage banks charge the same rate to all mortgage borrowers. This inefficiency in risk sharing between mortgage borrowers groups in the forward and spot housing markets leads to mispricing in secondary mortgage sales and mortgage-backed security trading. Keywords Mortgage . Prepayment . Default . Credit risk . Forward contract . Pre-sale JEL Classification G12 . G14 . G21 . H31 Introduction The residential mortgage market in China has grown rapidly since 1998, with an average annual growth rate of roughly 100%. By the end of the first quarter of 2005 Y. Deng University of Southern California, 650 Childs Way, RGL 201A, Los Angeles, CA 90089-0626, USA e-mail: ydengusc.edu P. Liu (*) Cornell University, 465 Statler Hall, Ithaca, NY 14853, USA e-mail: pl333cornell.edu Mortgage Prepayment and Default Behavior with Embedded Forward. 215 the outstanding balance of residential mortgages reached 1.7 trillion RMB Yuan (Fig. 1), approximately USD 207 billion.1 There are two highly distinctive features of the Chinese mortgage market: First, the Peoples Bank of China (the central bank in China) sets the mortgage rate, which applies to all borrowers.2 Second, beyond the standard spot market for existing housing transactions, there is an active forward real estate market in the sense that the developer can sell a housing unit before its completion, sometimes even before construction begins. A pre-sale practice that distinguishes Chinas housing market from other housing markets is the timing of the fund allocated to developers. In many housing markets around the world, the funds (which typically consist of a certain percentage of the purchasing price of the property) are put into an escrow account and allocated to the developer gradually according to the progress made in building the development. In China, however, at least before 2007, funds are transferred to the project developer all at once. At the closing time of such a pre-sale, the purchaser can either pay the pre-sale price in full or finance a certain amount (usually 80% of the purchasing price during the period of 1998 to 2003) from a bank. As a result, during the pre- sale3 period home buyers face a significant forward contract risk. However, since home buyers in China are allowed to borrow a standard mortgage from a bank to finance such a pre-sale unit, home buyers in the pre-sale housing market share the forward contract risk with banks. This explains the phenomenon of irregularly high early-stage default and prepayment rates observed in residential mortgage lending in China, where there are few if any financial incentives for mortgage borrowers to exercise either put or call options. A consumer (home buyer) in Chinas forward housing market will choose to default her mortgage contract if the developer defaults the forward housing contract. If the forward housing unit is delivered, the consumer may choose to prepay the loan depending on her liquidity constraints and returns through alternative investment channels. Because of the embedded risk of developer default, mortgages collateralized on pre-sold properties are more risky than their counterparts on the spot market are. Chinas pre-selling system is among its unique practices undertaken during economic reform as it transitions from a central planning economy to a market- oriented economy. Understanding the institutional differences in Chinas housing market not only helps us correctly adjust housing or mortgage pricing in these markets, but it also sheds light on studies of other financial puzzles in the emerging economy. This is particularly relevant given the size of Chinas economy and the trend towards global financial integration. This paper studies the competing risks of mortgage prepayment and default with embedded forward contract risk of developers default. The economic model is based upon the Cox proportional hazard model of mortgage termination (Cox 1972, 1975). The empirical analysis is based upon a rich set of mortgage-lending data from 1 As of March 2007 the exchange rate of Chinese Yuan (CNY) is one U.S. dollar=7.74 CNY. 2 There is a long history of not using risk-based interest rates in China or other central-planning economies. It is also a tradition that in those countries a unified product or service is provided to all consumers. 3 We use the terms forward market and pre-sell market interchangeably. 216 Y. Deng, P. Liu a leading mortgage lender in China. The loan history dataset contains not only mortgage loan characteristics, but also information about borrowers and developers. The unique dataset allows us to study mortgage borrowers prepayment and default behavior with embedded forward contract risks. The finding of this study will provide valuable insights into emerging housing and mortgage markets in China as well as those in other transitional economies. The remainder of the paper is organized as follows. Section The Mortgage and Housing Markets in China describes the Chinese mortgage market in detail, including both the single mortgage rate constraint and the forward market for new units. Section The Data describes the data used in this study. Section The Empirical Model and Estimation Methodology lays out the empirical methodology. Section Empirical Results presents a discussion of the empirical results. A brief conclusion follows. The Mortgage and Housing Markets in China The long history of the real estate and consumer loan markets in China was transformed abruptly in 1949, when China adapted the central planning system. For a long period of time, under the central planning regime, housing in China had been treated as a social welfare product administrated and delivered by state agencies (e.g., state-owned enterprisesSOEsand housing bureaus) for its people. Under such a welfare-oriented system, the private housing market and the residential mortgage system were extinguished. The mission of Chinese banks was to act as government-directed funding sources for SOEs. Since the early 1980s, China has gradually restructured its housing system. Market mechanisms, with the objectives of eliminating state housing allocations, promoting the privatization of public housing, and encouraging private housing development, were introduced in stages to replace the welfare housing system. Although Chinas first modern residential mortgage loan was issued in 1986 by the China Construction Bank (CCB), the mortgage market did not play an important role in the Chinese residential housing market for another decade. By the end of 1997, the total outstanding mortgage balance in the Peoples Republic of China was only approximately 19 billion RMB Yuan (USD 2.35 billion). In 1998, the Peoples Bank of China, which functions as the central bank of China, and the State Council of China announced several administrative laws to speed up housing construction and intensify urban housing reform. The State Council announced that, among these measures, it would no longer allow SOEs to allocate welfare housing to their employees after December 31, 1999. At that point residential mortgage lending began to accelerate. By the end of 2005 the outstanding balance of residential mortgages exceeded two trillion RMB Yuan (USD 198 billion), almost 89 times the 1997 balance. Residential mortgages play an increasingly important role in Chinese banks lending activities. The outstanding mortgage balance constitutes more than 12% of total loans made by financial institutions in the same period in 2005, compared with less than 0.4% in 1997. Although mortgage lending currently constitutes about 85% of total consumer lending, the ratio of mortgage loans to total loans was 7.5% in 2003, which is lower than it is in most developed countries (e.g., the ratio of mortgages to total loans is Mortgage Prepayment and Default Behavior with Embedded Forward. 217 Billion RMB Yuan39% in the U.S. and 59% in the U.K.), and even lower than in other countries in the Asia-Pacific region (Fig. 2). Therefore there is much room for continuing growth in Chinas mortgage lending practice. For details on the background of mortgage lending in China, please refer to Deng et al. (2005). Risk Management in Chinese Mortgage Banking Lending activities in Chinas residential mortgage markets are dominated by four major state-owned banks. They account for more than 90% of the total outstanding mortgage balance. Of these four banks, Industrial and Commercial Bank of China (ICBC) and China Construction Bank (CCB) are the two leading mortgage lenders, representing about 70% of total outstanding mortgage loans. Chinese banks adopted a five-category system to manage the default risks of mortgage portfolios in 2003. The five default-risk categories are Prime, Subprime, Irregular, Distress, and Default. Before approval of a loan, a bank investigates the credit worthiness of each applicant. The bank will approve a mortgage to an applicant according to several borrower characteristics such as family income, occupation, etc. Therefore there are only two pre-lending classes: Prime and Subprime. The bank watches the borrowers payment behaviors carefully and makes frequent adjustments to the borrowers risk level if it sees any warning signals. In particular, if the number of delinquencies is between three and six, the mortgage borrowers risk level becomes Irregular; if the number of delinquencies is above six then the borrowers risk level becomes Distress. The last category in the five- category risk level is Default. The headquarters of a mortgage lending bank also actively monitors its branches and subsidiaries. An early warning is given to branches with a 1%-to-3% delinquency rate in their mortgage loan portfolios; the headquarters requires a reorganization of mortgage operations at branches whose 2500 14.00% 2000 1500 12.00% 10.00% 8.00% 1000 6.00% 500 4.00% 2.00% 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 0.00% Total Mortgage Outstanding Ratio of Mortgage to Total Bank Loans Fig. 1 Residential mortgage market in China 218 Y. Deng, P. Liu delinquency rate falls between 3% and 5%; the mortgage lending license would be revoked if a branch has a greater-than-5% delinquency rate. The Pre-Sell Practice in Chinas Housing Market Just as consumers can purchase financial instruments, they can also buy real estate either on the spot market or on the forward market (pre-sales). On the spot market, consumers and developers transact on existing housing units-housing stock; while on the forward market, consumers and developers agree on the price at the date of sale but the underlying property, which is not yet completed, is transferred to the buyer only at a certain later time, usually at the date of completion. Because the unit is sold well before completion and occupation, the forward contract is often called a pre- sale or pre-construction transaction. Mainland China adopted the pre-sale system in 1994, after the Chinese Ministry of Construction established Urban Housing Pre-Sale Management Approaches. Now a majority of residential housing units in urban China are transacted on the forward or pre-sale market. Developers usually sell condominium units well before completion, usually one to 3 years before,4 in order to hedge development risks and acquire additional funding. Pre-selling exists not only in China, but it is also a popular practice in most emerging Asian markets and in some developed countries. For example, Ong (1997, 1999) studied the pre-sale market in Singapore; Chang and Ward (1993) studied the pre-sale market in Taiwan; and Chau et al. (2003, 2007), Yiu et al. (2005) and Wong et al. (2006) studied the Hong Kong market. In the United States, pre-selling of buildings and resort condominiums (in Miami and Hawaii, for example) has become a standard process, and virtually every condominium is pre- sold today.5 The procedures involved in forward sales vary from market to market, and sometimes from developer to developer, along the following dimensions: length of pre-sale period, size of down-payment/deposit, payment schedule, refund policy in case of developer default, and eligibility for mortgage loan and mortgage rate. The most important feature that distinguishes pre-sale practices in Chinas housing market from those in other markets is the timing of the fund allocated to developers. In most markets, such funds (which typically consist of a certain percentage of the purchasing price of the pre-sale properties) are put into an escrow account and allocated to the developer gradually according to the progress made in building the development. In Chinas housing market, however, at least before 2007, funds are transferred to the project developer all at once. At the closing time of such a pre-sale, the purchaser can either pay the pre-sale price in full or finance a certain amount (usually 80% of the purchasing price during the period of 1998 to 2003) from a bank. This special design in the pre-sale system is again due to Chinas housing reform (See Yi and Huang 2007). Starting in the early 1990s, as the middle- income class has expanded, its pent-up demand for housing has been unleashed; 4 The pre-sale period used to be around four years, but has now decreased to one to two years. 5 A sample pre-sale contract can be found at the Miami real estate Web site, http:/www.miamirealestate- trends.com Mortgage Prepayment and Default Behavior with Embedded Forward. 219 Percentage ofTotalLoan50% 45% 8.7% 40% 35% 30% 25% 3.7% 2.7% 6.7% 3.3% 4.9% 2.6% 16.0% 1.3% 2.4% 20% 15% 10% 1.4% 3.7% 2.0% 26.3% 29.5% 34.3% 27.3% 38.8% 0.0% 5% 7.5% 9.1% 0% China Thailand Malaysia Taiwan Hong Kong Singapore U.S. Mortgage Credit Card Loan Other consumer Loan Fig. 2 International comparison of mortgage to consumer loan ratio (2003) furthermore, employees c