Mortgage Prepayment: Economically Suboptimal

Greg Mankiw reckons that prepayment penalties are a Bad Thing, and approves of David Laibson's plan to abolish them. Writes Mankiw:

When I refinanced my mortgage not long ago, one of my first questions was, Are there any prepayment penalties? I figured that as long as the answer was no, I was less likely to be hit with strange, hidden provisions down the road.

Mankiw's commenters (and Brad DeLong's, too) get into a healthy debate about this proposal, but now Tomasz Piskorski and Alexei Tchistyi have a long paper out which claims with great empirical rigor that in a perfect world the exact opposite would be true. Instead of no mortgages having prepayment penalties, all mortgages would ban prepayment altogether, or at least have very large prepayment penalties.

Peter Coy tries to explain, in English:

The economists say the optimal loan contract would outright ban getting a new loan from a different lender. There are no such bans. But they say that the prepayment penalties that are common in subprime loans are a good second best. How could that be? Because lenders will offer more favorable terms if they know that they'll be able to hang onto the loan long enough for it to be profitable. If they fear that the borrower will refinance at the drop of a hat, they'll give less favorable terms.

In fact it's slightly more complicated than that. Here's what the paper says:

The optimal contracts do not allow borrowers to refinance their mortgages with another lender. Offering this option would increase the borrower's reservation value, which would limit the ability to provide him incentives to repay his debt, resulting in a decrease of efficiency of the contract.

I'm not going to try to get into the specifics of reservation value (see page 11 of the paper for all the details), but it's basically homeowner's equity: the amount of money that the borrower would have left over if he sold the house and moved.

Indeed, the paper says that not only prepayment but even renegotiation is a bad idea in an economically-optimal mortgage:

We also did not allow for contract renegotiations, because a possibility of renegotiation would lead to a suboptimal contract.

I have to say that I'm having a lot of difficulty with this idea: since a successful renegotiation has to be acceptable to both sides, what's not to like about it? If the lender would be better off with the original contract, it can simply refuse to renegotiate.

In any case, I'm sure that Greg Mankiw, who recently refinanced his mortgage, is happy that he was able to do so. But it is interesting that in some kind of ideal world, there would be enormous-to-the-point-of-insurmountable obstacles preventing him from doing just that.

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