No Job, No Money, No Refi: Frictions to Refinancing in a Recession

• Date: 01 October 2020
• Author: ANTHONY A. DEFUSCO,JOHN MONDRAGON
• DOI: http://doi.org/10.1111/jofi.12952
• Published date: 01 October 2020

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 5 •OCTOBER 2020

No Job, No Money, No Refi:

Frictions to Refinancing in a Recession

ANTHONY A. DEFUSCO and JOHN MONDRAGON∗

ABSTRACT

We study how employment documentation requirements and out-of-pocket closing

costs constrain mortgage refinancing. These frictions, which bind most severely dur-

ing recessions, may significantly inhibit monetary policy pass-through. Tostudy their

effects on refinancing, we exploit a Federal Housing Administration policy change

that excluded unemployed borrowers from refinancing and increased others’ out-of-

pocket costs substantially. These changes dramatically reduced refinancing rates,

particularly among the likely unemployed and those facing new out-of-pocket costs.

Our results imply that unemployed and liquidity-constrained borrowers have a high

latent demand for refinancing. Cyclical variation in these factors may therefore affect

both the aggregate and distributional consequences of monetary policy.

FRICTIONS THAT PREVENT HOUSEHOLDS FROM refinancing their debt during

times of economic distress can significantly inhibit policy efforts aimed at cur-

tailing the costs of recessions. This was particularly true during the Great Re-

cession, when frictions in the U.S. mortgage market held back a broad array of

policies directed at providing debt relief and economic stimulus to households.

These frictions ranged from widespread levels of negative equity,which limited

the ability of many households to benefit from accommodative monetary policy

∗Anthony A. DeFusco and John Mondragon are with the Kellogg School of Management at

Northwestern University. We thank seminar participants at the Bank of England, BYU, the Cen-

tral Bank of Ireland, Stanford, UC Berkeley,NYU, HUD, ITAM, LSE, the Federal Reserve Board,

the Federal Reserve Bank of Philadelphia, and the FederalReserve Bank of San Francisco; as well

as conference participants at the NBER Monetary Economics meeting, SITE Financial Regulation

session, NYU Household Finance Conference, SED, the New York Fed Conference on Develop-

ments in Empirical Macroeconomics, the University of Washington Summer Finance Conference,

the Texas Finance Festival,the Pre-WFA Real Estate Conference, the UW Madison Conference on

Real Estate, and the AREUEA National Conference, for comments and suggestions. We are espe-

cially grateful to our discussants Hamilton Fout, Andra Ghent, Tim McQuade, and Wenlen Qian.

Finally,we would like to thank Brent Ambrose, George Baker, and Brian Chappelle for very helpful

conversations regarding institutional details of the FHA and the Streamline Refinance Program.

The authors gratefully acknowledge financial support from the Guthrie Center for Real Estate

Research at Northwestern University. Both authors have read The Journal of Finance disclosure

policy and have no conflicts of interest to disclose.

Correspondence: Anthony DeFusco, Kellogg School of Management, Northwestern Univer-

sity, 2211 Campus Drive, Office 4463, Evanston, IL 60208; e-mail: anthony.defusco@kellogg.

northwestern.edu.

DOI: 10.1111/jofi.12952

© 2020 the American Finance Association

2327

2328 The Journal of Finance®

(Beraja et al. (2019)), to competitive barriers in the mortgage market, which

suppressed the take-up of federal mortgage modification and refinancing pro-

grams (Agarwal et al. (2017a,2017b)).1

In this paper, we study how two previously overlooked but important fric-

tions may contribute to a lack of refinancing during recessions. To refinance a

mortgage, borrowers typically need to both document that they are employed

and pay upfront, out-of-pocket closing costs. Although always present, these

constraints may be especially binding during recessions, when unemployment

is high, income risk is elevated, and cash-on-hand is low. They are also likely

to have significant distributional implications. The households who are most

affected—the unemployed and the liquidity-constrained—are precisely those

who would benefit most from refinancing into a lower interest rate. Yet, de-

spite their potential importance, little is known about the extent to which these

constraints actually bind in practice.

To quantify the effect of these frictions on refinancing in a recession, we ex-

ploit a sharp policy change introduced by the Federal Housing Administration

(FHA) during the height of the Great Recession. Prior to late 2009, borrowers

with an FHA mortgage were typically not constrained by out-of-pocket clos-

ing costs or employment documentation requirements. Instead, these borrow-

ers were allowed to roll all closing costs into their new mortgage and were

not required to provide any income or employment documentation so long as

they refinanced into a new FHA mortgage through the FHA’s Streamline Refi-

nance (SLR) Program. However, in response to the general deterioration in the

mortgage market, the FHA eliminated both of these provisions from the SLR

Program in late 2009. Under the revised program, borrowers with negative eq-

uity had to pay for any upfront refinancing fees out-of-pocket, and unemployed

borrowers were prohibited from refinancing altogether.2Changes in refinanc-

ing rates among FHA borrowers following the policy change should therefore

be informative about both the latent demand for refinancing among the un-

employed and the extent to which upfront costs inhibit refinancing during a

recession.

To identify the combined effect of these changes to the SLR Program, we

begin with a simple event study that exploits the sharp timing of the policy

change. Graphical analysis reveals that refinancing rates among FHA borrow-

ers experienced an exceptionally large and discrete fall in precisely the month

that the policy changes took effect. This drop in refinancing persists even after

controlling flexibly for time trends and a large set of borrower- and loan-level

observables. Our baseline estimates imply that the policy reduced the monthly

probability that an FHA borrower refinanced her mortgage by a full percentage

1See Piskorski and Seru (2018) for a comprehensive review of the literature studying how

mortgage market frictions interacted with household debt relief and restructuring attempts during

the Great Recession.

2Crucially, the FHA did not change its policy on home equity and refinancing. FHA borrowers

with negative equity were still permitted to refinance through the SLR Program as long as they

could pay for the closing costs and prove that they were employed.

No Job, No Money, No Refi 2329

point, which amounts to a decline of roughly 80% relative to the pre-shock av-

erage.

Although these results strongly suggest that the policy change had a neg-

ative effect on refinancing, the event study approach cannot completely rule

out the possibility that the drop in FHA refinancing was driven by concur-

rent macroeconomic shocks. To address this concern, we estimate difference-

in-differences specifications that use the unaffected conventional (non-FHA)

market as a control group. This approach is motivated by a similar graphical

analysis of refinancing in the conventional market, which does not reveal any

discrete changes around the time of the policy change. Including conventional

borrowers as a control group allows us to fully and nonparametrically control

for aggregate trends in refinancing rates and yields results that are similar

to the event study analysis. Across a range of specifications, we estimate that

the policy led to a reduction in the monthly FHA refinancing rate of roughly

0.7 percentage points, which is more than 50% of the baseline rate. Finally, to

further support our approach, we estimate flexible specifications that allow the

effect on FHA refinancing to vary by month and find that the differential fall in

refinancing among FHA borrowers coincides exactly with the implementation

of the policy change. Taken together, these results provide strong evidence that

the policy changes had a large negative effect on FHA refinancing rates.

Having documented the combined effect of the new employment documenta-

tion and closing cost requirements on refinancing rates among FHA borrowers,

we then turn to examining the effects of these two provisions separately. We

identify these effects using a triple-differences approach that compares how

the post-policy fall in FHA refinancing relative to conventional refinancing

varies across groups of borrowers who are more or less likely to be affected

by each of the two constraints.

To isolate the effect of the employment documentation requirement, we use

variation in the likelihood that a borrower is unemployed based on changes

in county-level unemployment rates. Specifically, we take the difference in re-

financing rates between borrowers in high- and low-unemployment counties,

before and after the policy, and across FHA and conventional borrowers. Our

estimates show that the post-policy fall in refinancing among FHA borrowers

was substantially larger in high- relative to low-unemployment counties, but

that there was no differential change in refinancing behavior among conven-

tional borrowers across these two groups of counties. Our baseline estimate

suggests that raising the county-level unemployment rate by one percentage

point reduces the monthly probability that an FHA borrower refinances by

about 0.05 percentage points following the policy change. These estimates are

robust to our full set of controls, and the timing of the effect is consistent with

the change in FHA policy. Importantly, these results are not caused by the si-

multaneously imposed new requirement that negative-equity FHA borrowers

pay for closing costs out-of-pocket. We estimate all of our specifications only in

the subsample of borrowers with positive equity and, in the preferred specifica-

tion, allow for the level of home equity to have a fully flexible and time-varying

independent effect on relative refinancing rates of FHA borrowers.