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FRB St. Louis Research on Subprime Mortgages January 2006

FRB St. Louis Research on Subprime Mortgages January 2006

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Published by Michael Taylor
A time capsule of research on the subprime mortgage market, before subprime became a dirty word.
A time capsule of research on the subprime mortgage market, before subprime became a dirty word.

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Published by: Michael Taylor on Oct 09, 2012
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FEDERAL RESERVE BANK OF ST
.
LOUIS
REVIEW 
JANUARY
/
FEBRUARY
2006
31
The Evolution of the Subprime Mortgage Market 
Souphala Chomsisengphet and Anthony Pennington-Cross
Of course, this expanded access comes witha price: At its simplest, subprime lending can bedescribed as high-cost lending.Borrower cost associated with subprimelending is driven primarily by two factors: credithistory and down payment requirements. Thiscontrasts with the prime market, where borrowercost is primarily driven by the down paymentalone, given that minimum credit history require-ments are satisfied.Because of its complicated nature, subprimelending is simultaneously viewed as having greatpromise and great peril. The promise of subprimelending is that it can provide the opportunity forhomeownership to those who were either subjectto discrimination or could not qualify for a mort-gage in the past.
1
In fact, subprime lending is most
INTRODUCTION AND MOTIVATION
H
omeownership is one of the primaryways that households can build wealth.In fact, in 1995, the typical householdheld no corporate equity (Tracy, Schneider, andChan, 1999), implying that most households findit difficult to invest in anything but their home.Because homeownership is such a significanteconomic factor, a great deal of attention is paidto the mortgage market.Subprime lending is a relatively new andrapidly growing segment of the mortgage marketthat expands the pool of credit to borrowers who,for a variety of reasons, would otherwise be deniedcredit. For instance, those potential borrowers whowould fail credit history requirements in the stan-dard (prime) mortgage market have greater accessto credit in the subprime market. Two of the major benefits of this type of lending, then, are theincreased numbers of homeowners and the oppor-tunity for these homeowners to create wealth.
This paper describes subprime lending in the mortgage market and how it has evolved throughtime. Subprime lending has introduced a substantial amount of risk-based pricing into the mortgagemarket by creating a myriad of prices and product choices largely determined by borrower credithistory (mortgage and rental payments, foreclosures and bankruptcies, and overall credit scores)and down payment requirements. Although subprime lending still differs from prime lending inmany ways, much of the growth (at least in the securitized portion of the market) has come in theleast-risky (A–) segment of the market. In addition, lenders have imposed prepayment penaltiesto extend the duration of loans and required larger down payments to lower their credit riskexposure from high-risk loans.Federal Reserve Bank of St. Louis
Review 
, January/February 2006,
88
(1), pp. 31-56.
1
See Hillier (2003) for a thorough discussion of the practice of “redlin-ing” and the lack of access to lending institutions in predominatelyminority areas. In fact, in the 1930s the Federal Housing Authority(FHA) explicitly referred to African Americans and other minoritygroups as adverse influences. By the 1940s, the Justice Departmenthad filed criminal and civil antitrust suits to stop redlining.Souphala Chomsisengphet is a financial economist at the Office of the Comptroller of the Currency. Anthony Pennington-Cross is a senioreconomist at the Federal Reserve Bank of St. Louis. The views expressed here are those of the individual authors and do not necessarilyreflect the official positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System, the Board of Governors, the Office of Comptroller of the Currency, or other officers, agencies, or instrumentalities of the United States government.
©
2006, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted intheir entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be madeonly with prior written permission of the Federal Reserve Bank of St. Louis.
 
prevalent in neighborhoods with high concentra-tions of minorities and weaker economic condi-tions (Calem, Gillen, and Wachter, 2004, andPennington-Cross, 2002). However, because poorcredit history is associated with substantially moredelinquent payments and defaulted loans, theinterest rates for subprime loans are substantiallyhigher than those for prime loans.Preliminary evidence indicates that theprobability of default is at least six times higherfor nonprime loans (loans with high interest rates)than prime loans. In addition, nonprime loansare less sensitive to interest rate changes and, asa result, subprime borrowers have a harder timetaking advantage of available cheaper financing(Pennington-Cross, 2003, and Capozza andThomson, 2005). The Mortgage Bankers Associa-tion of America (MBAA) reports that subprimeloans in the third quarter of 2002 had a delin-quency rate 5
1
/
2
times higher than that for primeloans (14.28 versus 2.54 percent) and the rate atwhich foreclosures were begun for subprime loanswas more than 10 times that for prime loans (2.08versus 0.20 percent). Therefore, the propensityof borrowers of subprime loans to fail as home-owners (default on the mortgage) is much higherthan for borrowers of prime loans.This failure can lead to reduced access tofinancial markets, foreclosure, and loss of anyequity and wealth achieved through mortgagepayments and house price appreciation. In addi-tion, any concentration of foreclosed property canpotentially adversely impact the value of propertyin the neighborhood as a whole.Traditionally, the mortgage market set mini-mum lending standards based on a borrower’sincome, payment history, down payment, and thelocal underwriter’s knowledge of the borrower.This approach can best be characterized as usingnonprice credit rationing. However, the subprimemarket has introduced many different pricing tiersand product types, which has helped to move themortgage market closer to price rationing, or risk- based pricing. The success of the subprime marketwill in part determine how fully the mortgagemarket eventually incorporates pure price ration-ing (i.e., risk-based prices for each borrower).This paper provides basic information aboutsubprime lending and how it has evolved, to aidthe growing literature on the subprime marketand related policy discussions. We use data froma variety of sources to study the subprime mort-gage market: For example, we characterize themarket with detailed information on 7.2 millionloans leased from a private data provider calledLoanPerformance. With these data, we analyzethe development of subprime lending over thepast 10 years and describe what the subprimemarket looks like today. We pay special attentionto the role of credit scores, down payments, andprepayment penalties.The results of our analysis indicate that thesubprime market has grown substantially overthe past decade, but the path has not been smooth.For instance, the market expanded rapidly until1998, then suffered a period of retrenchment, butcurrently seems to be expanding rapidly again,especially in the least-risky segment of the sub-prime market (A– grade loans). Furthermore,lenders of subprime loans have increased theiruse of mechanisms such as prepayment penal-ties and large down payments to, respectively,increase the duration of loans and mitigate lossesfrom defaulted loans.
WHAT MAKES A LOAN SUBPRIME?
From the borrower’s perspective, the primarydistinguishing feature between prime and sub-prime loans is that the upfront and continuingcosts are higher for subprime loans. Upfront costsinclude application fees, appraisal fees, and otherfees associated with originating a mortgage. Thecontinuing costs include mortgage insurancepayments, principle and interest payments, latefees and fines for delinquent payments, and feeslevied by a locality (such as property taxes andspecial assessments).Very little data have been gathered on theextent of upfront fees and how they differ fromprime fees. But, as shown by Fortowsky andLaCour-Little (2002), many factors, including borrower credit history and prepayment risk, cansubstantially affect the pricing of loans. Figure 1compares interest rates for 30-year fixed-rate loansin the prime and the subprime markets. The
Chomsisengphet and Pennington-Cross
32
JANUARY
/
FEBRUARY
2006
FEDERAL RESERVE BANK OF ST
.
LOUIS
REVIEW 
 
Chomsisengphet and Pennington-Cross
FEDERAL RESERVE BANK OF ST
.
LOUIS
REVIEW 
JANUARY
/
FEBRUARY
2006
33
0246810121995199619971998199920002001200220032004In
t
ere
st
Ra
t
e a
t
Ori
g
ina
t
ion
S
ub
p
rime
S
ub
p
rime PremiumPrime
Figure 1
Interest Rates
NOTE:Prime is the 30-year fixed interest rate reported by the Freddie Mac Primary Mortgage Market Survey.Subprime is the average30-year fixed interest rate at origination as calculated from the LoanPerformance data set.The Subprime Premium is the differencebetween the prime and subprime rates.
0123451998199920002001200220032004Ra
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e Normalize
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S
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Figure 2
Foreclosures In Progress
NOTE:The rate of foreclosure in progress is normalized to 1 in the first quarter of 1998.MBAA indicates the source is the MortgageBankers Association of America and LP indicates that the rate is calculated from the LoanPerformance ABS data set.

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