Calif. professor releases working paper
By COCO SALAZAR
2/15/2006

Prepayment penalties save borrowers -- especially subprime borrowers -- millions of dollars, according to an analysis from a California university which also suggests more could be saved with uniform national restrictions.

In his working paper, Call Protection in Mortgage Contracts, Michael LaCour-Little, Professor of Finance at Cal State Fullerton, said his research "strongly support[s] the view that this contract feature has significant economic value to both borrowers and lenders and that, hence, the trend toward greater legal restrictions is misguided, potentially harming those it is intended to help."

The author acknowledged help from Richard DeMong, a professor for the University of Virginia's McIntire School of Commerce who has previously prepared studies for the National Home Equity Mortgage Association, and Amy Crews Cutts, a Freddie Mac economist.

Prepayment penalties have become a sensitive topic in the subprime market, which during 2004 surged 60% to $324 billion. In 2000, approximately 80% of subprime mortgages contained prepayment penalties, and they are increasingly found in some prime adjustable-rate instruments, according to the paper.

"Housing and consumer activists tend to condemn prepayment penalties on consumer protection grounds, arguing that they are either inherently unfair, unreasonably expensive, and/or inadequately disclosed, or simply misunderstood by borrowers," the author said in the paper. Meanwhile, many "state and local legislative bodies have taken up the cause of limiting allowable prepayment penalties."

Amongst the different limitations, North Carolina prohibits such contract terms entirely on loans with an original balance of $150,000 or less, Pennsylvania prohibits them on loans smaller than $50,000 but allows them for up to five years provided the same loan product is also available without a prepayment penalty, while Illinois restricts penalties to the first three years and caps their amount at 3% of the loan amount during the first year, 2% in the second year, and 1% in the third year.

"The cost of compliance with so many divergent statutes to lenders is significant, of course, and there have been calls for federal legislation in this arena," LaCour-Little said, noting the recent Ney-Kanjorski Responsible Lending Act.

At the heart of much of the criticism in subprime lending is the distributional issue -- that the cost of allegedly more onerous terms such as prepayment penalties are more likely to be borne by relatively lower-income households, according to the paper.

The professor said an overall pattern in his simulation valuations is that the incremental value of prepayment penalties is three to five times greater for subprime mortgages as compared to prime mortgages. "This simple economic fact helps explain the prevalence of this contract feature in the subprime market sector," the author writes.

Because subprime loans carry higher coupons and faster prepayment speeds, the reduction in coupon will be greater than would be the case for prime loans.

"In fact, subprime borrowers benefit from an option not generally available to prime borrowers and the effect of that option is to reduce their cost of credit," LaCour-Little says. "Moreover, the reduction in interest rates that subprime borrowers obtain is greater than that which would occur for prime rate loans" because subprime loans carry higher interest rates and prepay relatively more quickly than prime loans.

While previous research prepared for NHEMA showed that loans with prepayment penalties carry interest rates that are 38 basis points, on average, lower than otherwise comparable loans without them, LaCour-Little reportedly obtained even larger results -- ranging from 43 to 58 BPS, which translates into over $1 billion annually given the estimated size of the subprime market and the prevalence of call protection in those contracts.

"Hence, a move to completely eliminate prepayment penalties would cost borrowers in this market segment at least $1.0 billion annually," LaCour-Little said. "Policymakers would be wise to consider these issues carefully prior to further restricting the use of this valuable contract feature at the expense of the households they claim to wish to protect.

"If the distribution of the cost burden is the real issue, a targeted tax credit for lower income borrowers who actually incur prepayment penalties would seem to be a preferable alternative."

Article © MortgageDaily.com All Rights Reserved