Pricing Credit Risk for Mortgages: Credit Risk Spreads and Heterogeneity across Housing Markets

We develop a Monte Carlo procedure to project MSA-level house-price paths from 2013 to 2023. These price paths are applied to a fixed portfolio of synthetic mortgages in order to estimate credit risk spreads (CRS) for each MSA. Like the well-known annual percentage rate (APR)-which converts an array of fees into an all-encompassing annual measure of costs to borrowers-the CRS is a holistic measure that encompasses both expected losses from default plus the cost of capital (or unexpected credit losses) needed to cover losses in a stress scenario. We find variation in the CRS across MSAs, with the range spanning 37 basis points. This range spans 86 basis points for those carrying first-loss positions, such as private mortgage insurers. We conclude that, in order to accurately price credit risk, it is necessary to monitor more than borrower characteristics, but also local economic conditions.