Homeownership at Any Price
The residential mortgage horses are out of the barn: To the extent that borrowers and lenders could make bad decisions, most already have. From here on out, we are destined to witness and discuss the consequences.
Subprime loans, which have grown rapidly in recent years, are made to borrowers who are more likely to default than the most creditworthy borrowers. A loan is designated subprime not because it is bad in itself but because its terms and the borrower’s characteristics make it a riskier proposition for the lender. Blemishes in subprime borrowers’ credit histories range all the way from a few late payments to multiple bankruptcy filings. These borrowers also tend to put less of their own equity at risk than prime borrowers do. Another change in the lending process is the greater prevalence of the piggyback loan—a separate loan of up to 20 percent of the home purchase price, which gives the buyer enough money for a down payment and creates a loan-to-value ratio of 100 percent (equity is so over). Prospective lenders consider both credit history and equity at risk, along with local laws that could affect their ability to take title of the property, to determine the expected loss from default, and, hence, the ultimate designation of loan quality.
The subprime market has expanded dramatically during the past 10 years because lenders can quickly, cheaply, and accurately assess a borrower’s default risk based on the individual’s personal circumstances (but just how accurately remains to be seen). At the same time, borrowers have been willing to accept loan offers whose prices and terms are predicated on their circumstances. In the retail industry, marketing strategists would describe this as “mass customization.” Historically, the alternative for most subprime borrowers would have been a flat-out denial of credit.1
At one level, the subprime mortgage market closely resembles the prime market. Lenders come in many forms, from commercial banks and thrifts, to mortgage affiliates of bank holding companies, to companies that only originate mortgage loans. Some originate and hold their mortgages; others sell them off through their own offices, through independent brokers, or through both. There are plenty of similarities on the borrower’s side as well. Some take out loans for home purchases, some for refinance, and others for home improvements. Some borrowers seek to take cash out of their existing home equity; others do not.
From another perspective, however, the subprime and prime markets differ greatly. There is evidence that lower-income borrowers, those whose loan amounts are relatively small, and those using piggy-back loans are more likely than prime borrowers to pay higher financing rates. And there are some lenders who specialize in making subprime loans on a very significant scale with the express purpose of selling them to remote investors who are looking for financial instruments with high yields.
During the past few years, subprime loans have grown to roughly 20 percent of home mortgage originations; within that category, adjustable-rate mortgages have become the dominant type. In many cases, both parties to the loan were counting on house price appreciation to compensate for the borrower’s risky cash flow. In poker, this strategy is called betting on the come. As we now know, short-term interest rates rose by about 400 basis points between the summers of 2004 and 2006. The fact that a high proportion of these adjustable-rate loans carried prepayment penalties—which typically lowered the interest rate at the time of loan origination—added to borrowers’ woes. A similar fate awaits those whose interest-rate reset dates are still to come.
The available data suggest that the average subprime borrower has less income and education than the prime-rate borrower, and, by definition, has a somewhat checkered credit history. For example, a Federal Reserve Board study2 finds that in 2005 the incidence of higher-priced loans originated for owner-occupied homes varied from a low of 4 percent (Ithaca, New York) to a high of 53 percent (McAllen, Texas). Per capita income in the McAllen MSA, one of the poorest in the nation, is half the national average (Ithaca’s per capita income is nearly the same as the national average, and its educational attainment is much higher.)
Most of the statistics we see reflect the average experience of millions of people who differ markedly in their reasons for seeking higher-priced credit and in their experiences of obtaining it, but an average can mask many important differences in borrowers’ circumstances. Some may be wealthy, financially savvy people speculating in the purchase of a vacation property; others may be less-educated, elderly people refinancing their homes to raise cash for daily living expenses. Some have obtained their mortgage from a neighborhood banker, while others were solicited to borrow from a company they had never heard of. Although most people knew exactly what they were doing, many, it seems, did not.
The financial markets are already punishing those, borrowers and lenders alike, who thought they had made smart moves and only belatedly realized their mistakes. The subprime market will not disappear, because subprime borrowers will not. But we can expect that both borrowers and lenders will learn from recent experience and that the market will adjust. Thomas Jefferson wrote in 1790 that “[o]ur business is to have great credit and to use it little.” For people to use credit more sparingly may be too much to expect nowadays, but perhaps we may hope that it will be used—and sold—more carefully. What seems too good to be true is often just that.
1. For a good overview of the subprime mortgage market, see “The Evolution of the Subprime Mortgage Market” by Souphala Chomsisengphet and Anthony Pennington-Cross in the Federal Reserve Bank of St. Louis, Review, January/February 2006, pp. 31–56. [Back to article]
2. Some very insightful information about higher-priced mortgage loans, borrowers, and lenders is provided by Robert B. Avery, Kenneth P. Bravoort, and Glenn B. Canner in “Higher-Priced Home Lending and the 2005 HMDA Data,” published in the September 2006 Federal Reserve Bulletin, pp. A123–A166. The authors use the term “higher-priced” rather than “subprime” because the HMDA data on loan pricing are based on specific thresholds above the interest rates on Treasury securities of comparable maturity: 3 percent for first liens and 5 percent for subordinated liens. [Back to article]