Depending on the source, the increase in subprime lending in recent years has been either a disaster in the making or an innovative way to provide more borrowers a chance at the American dream of homeownership and wealth accumulation. These divergent views bring to mind the "broken window fallacy" introduced by 19th century French economist Frederic Bastiat. He wrote that "To break, to destroy, to dissipate is not to encourage national employment...Destruction is not profitable." In today's environment it remains to be seen whether lending to borrowers who will likely eventually default and experience foreclosure enhances individual prosperity and promotes economic growth in the long run or simply creates financial distress. This article will explore some fundamental aspects of subprime lending in order to better assess whether subprime loans ultimately help or hinder borrowers, as Bastiat's message would suggest.
Subprime Lending and Nontraditional Mortgage Products
Subprime lending is defined as extending credit to borrowers who exhibit characteristics that show a significantly higher risk of default than traditional customers.1 This article addresses subprime borrowers who have chosen nontraditional mortgage products to finance the purchase of a home.2 The imploding subprime industry has been the focus of recent media and press headlines, but the link between subprime borrowers who default on their loans and their use of nontraditional products is less apparent. In testimonies before Congress, Federal Reserve officials have clearly made the connection that the recent deterioration in housing credit has been concentrated among a relatively narrow market of subprime borrowers who used adjustable-rate mortgages (ARMs), a common feature among nontraditional loans.3 The Federal Reserve Bank of Atlanta published an article in its Financial Update during the third quarter of 2005, which warned that most subprime mortgage holders would likely see a rise in monthly payments, thereby increasing the risk of foreclosure and the deterioration in the quality of mortgage-backed securities.4
The basic structure of nontraditional mortgage products is to exchange lower payments during an initial period for higher payments later. This product structure can also include the use of a reduced or no documentation feature in assessing the creditworthiness of the borrower and the simultaneous creation of a second-lien mortgage.5 Nontraditional loan products were not originally designed for subprime borrowers, but instead were directed at borrowers seeking flexible payment options who could otherwise qualify for prime interest rates. Subprime mortgages, however, are often marketed to applicants as having a low introductory interest rate (teaser rate) or payment plan that usually results in higher fees, mortgage balances, monthly payments, and interest costs in the future. A brief list of common types of nontraditional loans includes:
The common benefit among these loan types is the short-term affordability they provide potential borrowers. As a result, nontraditional mortgages can be viewed as unique products designed for borrowers who have special, short-term circumstances. A subprime borrower who purchases a nontraditional mortgage product would likely represent someone who does not just have impaired credit, but also who would be carrying a high debt relative to income upon obtaining the mortgage. The Federal Reserve's Survey of Consumer Finances (SCF) indicates that, from 1995 to 2004, census tracts in all income groups experienced gains in homeownership, with rates in lower-income tracts growing by 6 percent, somewhat faster than the 4 percent growth rate in higher-income tracts.6 The SCF data confirm that low income households were likely candidates for nontraditional loans over the last decade.
Today, a subprime borrower might want to purchase a nontraditional mortgage product to obtain housing at a favorable price in anticipation of improved credit, significantly higher future income, and/or cash flow holding other factors constant. However, recent data show that subprime loans have grown from $65 billion in 1995 to $665 billion in 2005, a ten-fold increase over a decade.7 It is not probable that so many borrowers have temporary, special circumstances that lead them to purchase nontraditional mortgage products. It is more likely that other factors are driving demand for these products. More specifically, nontraditional mortgage products may not be suitable for subprime borrowers who are less likely to have a change in financial circumstances that lead to significantly higher income or cash flow, as it will only result in debilitating household balance sheets in the future.
Consumer Preference for Financing Options
Residential real estate markets have experienced rapid appreciation in recent years. In some California and Florida housing markets, house prices as measured by nominal housing price indices have increased over 90 percent in the last three years due, in part, to market fundamentals and speculative behavior. Rapid house price appreciation can easily make homeownership unattainable for young or low-income borrowers regardless of credit history, thereby making subprime loans a very attractive means to buy a home. When short-term interest rates began to rise steadily in 2004, the option payment ARMs became more popular and extended the housing boom further. While house prices continued to soar, debt burdens simultaneously continued to rise because consumers were extracting equity from their homes to purchase home furnishings and make home improvements since personal savings rates were falling. Higher prices and debt burdens, combined with weak credit histories, created a fertile environment for subprime lending to flourish over the last decade as the desire to purchase and refinance homes grew. In such an environment, consumers preferred more financing options than fewer, and financial institutions were willing to oblige this demand, since interest rates were historically low.
Many market participants see marketing to subprime borrowers and the growth of innovative financial instruments, such as nontraditional loans, as leading to the "democratization of credit" that broadens access to homeownership. Others view subprime lending as an insidious form of predatory lending, which would make borrowers more disadvantaged than if they had not received a loan at all, undermining the goal of safety and soundness in banking. The federal banking agencies responded to these concerns by issuing guidance to address the risks to financial institutions posed by nontraditional residential mortgage products. This interagency guidance addressed the sharp increase in the number of financial institutions offering nontraditional mortgage products and the expansion of the market for these products (i.e., borrowers who are less likely to qualify for a similar-size mortgage under traditional terms and underwriting standards). The guidance formally recognizes that it is possible for subprime borrowers (using a credit score-based definition) to obtain nontraditional loans as well.
The guidance details the importance of carefully managing the risk inherent in these loans.8 Below are steps from the guidance which financial institutions should take to mitigate the risk.
There are specific guidelines within capital adequacy procedures that address subprime lending directly. Additional regulations exist to protect consumers from unscrupulous issuers of subprime loans and other abusive practices such as the Truth in Lending Act (TILA) or Regulation Z, TILA's implementing regulation. TILA was enacted by Congress to inform consumers about the cost of credit so they can make informed credit decisions and to protect consumers against unfair credit practices.9 Federal regulators require banks to comply with other consumer protection laws that include the Home Mortgage Disclosure Act (HMDA), the Equal Credit Opportunity Act (ECOA), and the Community Reinvestment Act (CRA).
Although CRA and later revisions provided banking institutions a strong incentive to lend in low- and moderate-income areas and in varied racial and ethnic communities, it appears that a significant portion of these loans are subprime loans.10 As a result, regulatory scrutiny of the subprime lending market is warranted to prevent disparate impacts on particular racial and ethnic groups when market conditions have a disproportionate adverse impact on the subprime market. Academic research suggests that racial disparities may exist in the origination of subprime loans. Immergluck and Wiles (1999) reported that more than half of subprime refinances originated in predominately African-American census tracts, whereas only one-tenth of prime refinances originated in predominately African-American census tracts.11
The Current Environment
Indicators of a slowing economy and a relatively low inflation, as well as inflation expectations, have prompted the Federal Reserve to stop its succession of interest rate increases. Job and income growth remain healthy, thereby providing economic support to borrowers who have subprime loans. Although mortgage interest rates have risen modestly beyond their recessionary levels from 2001, mortgage interest rates are still historically low. By the end of 2006, however, the financial press and market analysts have reported that a record number of homeowners with high-cost mortgages have fallen behind on their payments or are facing foreclosure.
The Mortgage Bankers Association quarterly survey noted that approximately 223,000 households with subprime loans foreclosed on their homes in the third quarter of 2006, and nearly 725,000 subprime borrowers missed payments.12 A recent study by the Center for Responsible Lending cites that 2.2 million subprime borrowers will lose their homes, one out of five subprime mortgages originated in the past two years will end in foreclosure, and up to $164 billion of wealth (equity) will be lost as housing appreciation slows or reverses.13 More importantly, the study finds that subprime loans with layered risks such as low or no documentation and prepayment penalties significantly increase the risk of foreclosure after controlling for borrower credit scores. This dismal account of the subprime market has taken place even though long-term interest rates and unemployment rates have remained low.
Subprime borrowers tend to have very limited options to avoid foreclosure. These borrowers will most likely either seek to refinance or try to recoup equity by selling their home. Business Week reported that more than one-fifth of homes with option ARM loans in 2004 and 2005 are worth less than their debt, and if prices fall, only 10 percent of this number could double. One reason for the housing price decline is increasing residential inventories and vacancies. As residential inventories and vacancies rise, subprime borrowers will be less likely to exercise the two common exit strategies, and they will not be able to escape foreclosure. High residential vacancies are important, as they signal to builders that supply forces are outstripping demand. Also, when an occupied home is sold, the seller will need to either buy or rent another house under normal circumstances. In aggregate, these typical transactions will cause a ripple effect through the economy. When a vacant home is sold, this ripple effect does not occur. The chart below indicates that vacant housing units for sale as a percentage of total housing units has risen sharply since 2002.14
Several other factors are creating distress for the subprime borrower:
Anatomy of a Subprime Loan
The table below shows the typical payment option for an option ARM on a $500,000 loan. Based on an initial rate of 7.38 percent and a 1 percent minimum payment rate, a borrower will have a monthly payment of $1,608.20, and $20,214.81 will get added to the balance of the loan. If the loan will reset a year and a half later to 7.95 percent while the borrower has only made minimum payments and the loan principle reaches 110 percent of the original loan balance, the minimum payment will jump to $4,107.86, and $50,357.28 will be added to the loan balance. It is very easy to see how payment resets can trigger immediate distress to the subprime borrower.
The segment of the market that offers nontraditional mortgages to subprime borrowers is inherently risky by design, as lenders provide the credit-challenged borrower with greater flexibility around repayment under special circumstances. Those special circumstances usually involve the borrowers' inability to afford the terms of a conventional loan contract due to the prevailing interest rate or required down payment. The market currently views the product as a financial tool to accommodate borrowers with weaker credit histories as opposed to a product that addresses a special, short-term deficiency in the borrower's financial profile. Research shows how borrowers who are currently experiencing financial difficulty or who could become financially vulnerable under a probable market scenario are more likely to default on a subprime loan. Greater mortgage defaults not only harm the borrower, but also depress real estate markets as homeowners exercise their option to walk away from their homes. Higher defaults and foreclosures spell lower profits for institutions that make these loans.
Recent mortgage finance research and financial press reports of known subprime lenders experiencing financial difficulty are not surprising, given that firms in the subprime industry in the past have either failed or were purchased by larger institutions.15 In April 2007, the financial press reported that New Century Financial Corp., once the nation's second-largest provider of mortgages to high-risk borrowers, filed for bankruptcy protection and fired 54% of its work force. The industry is poised for greater consolidation as many institutions are looking to exit their subprime businesses entirely or sell existing assets. Unless the industry changes its view of underwriting to one where credit is granted by the borrower's ability to repay the loan after the interest rate resets, the important lessons from Bastiat will be ignored, and the efficiency gained from innovative financial instruments will be lost.16
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.