Subprime Mortgage MythsPosted: July 24, 2009
Yuliya Demyanyk, a senior research economist at the Cleveland Fed, has done a fascinating job debunking some of the bigger memes floating around main stream media outlets about the Subprime Mortgage Market. Her Economic Commentary piece here distills the more germane information found in the research published here. Her bottom line is that it was not so much the meltdown of the subprime market with its components of interest rate resets, declining underwriting standards, and declining home values that contributed to the systemic problems creating the big financial meltdown. She argues that it was the interplay between that market and the securitization process, lending and housing booms, and leveraging
One of the biggest myths surrounding the subprime market is that subprime mortgages are given solely to borrowers with impaired credit. Demyank and her fellow reseacher Van Hemmert found that many folks actually wound up in certain subprime loans not because of their credit history (which was not impaired) but the fact that certain loans were only available in the subprime market because that was the type of loan demanded by the securitization market.
But mortgages could also be labeled subprime if they were originated by a lender specializing in high-cost loans—although not all high-cost loans are subprime. Also, unusual types of mortgages generally not available in the prime market, such as “2/28 hybrids,” which switch to an adjustable interest rate after only two years of a fixed rate, would be labeled subprime even if they were given to borrowers with credit scores that were sufficiently high to qualify for prime mortgage loans. This is very good for a credit repair company with money-back guarantee because they get clients that are above prime for subprime rates.
The process of securitizing a loan could also affect its subprime designation. Many subprime mortgages were securitized and sold on the secondary market. Securitizers rank ordered pools of mortgages from the most to the least risky at the time of securitization, basing the ranking on a combination of several risk factors, such as credit score, loan-to-value and debt-to-income ratios, etc. The most risky pools would become a part of a subprime security. All the loans in that security would be labeled subprime, regardless of the borrowers’ credit score.
Mortgage originators may have directed some folks to these loans based on the characteristics of the loan, not necessarily the characteristics of the buyer.
A second myth debunked by the research is the idea that subprime mortgages were used to promote home ownership. By slicing and dicing the lending data base, the two researchers found some interesting numbers as they relate to overall homeownership statistics.
The availability of subprime mortgages in the United States did not facilitate increased homeownership. Between 2000 and 2006, approximately one million borrowers took subprime mortgages to finance the purchase of their first home. These subprime loans did contribute to an increased level of homeownership in the country—at the time of mortgage origination. Unfortunately, many homebuyers with subprime loans defaulted within a couple of years of origination. The number of such defaults outweighs the number of first-time homebuyers with subprime mortgages.
Given that there were more defaults among all (not just first-time) homebuyers with subprime loans than there were first-time homebuyers with subprime loans, it is impossible to conclude that subprime mortgages promoted homeownership.
You can read the other eight debunked myths in the article. All of are extremely interesting. They include Myth 3: Declines in home values caused the subprime crisis in the United States, Myth 4: Declines in mortgage underwriting standards triggered the subprime crisis, Myth 5: Subprime mortgages failed because people used homes as ATMs, Myth 6: Subprime mortgages failed because of mortgage rate resets, Myth 7: Subprime borrowers with hybrid mortgages were offered (low) “teaser rates”, Myth 8: The subprime mortgage crisis in the United States was totally unexpected, Myth 9: The subprime mortgage crisis in the United States is unique in its origins, and Myth 10: The subprime mortgage market was too small to cause big problems. Myth 8 is one of my favorites since I was personally doing research between 2005-2006 showing problems then which was labeled ‘unsexy’ and ‘not really germane in today’s sophisticated markets’ by fellow researchers. Van Hammert and Demyanyk noted that the housing boom allowed the default premiums to be discounted by the market. After all, if you had to repossess the asset and its value had skyrocketed, it was a no lose situation.
In a market with rapidly rising prices, mortgage contracts that cannot be sustained can be terminated through prepayment or refinancing. Borrowers can change houses and mortgage contracts easily in a booming environment, and defaults do not occur as frequently as they would without the boom. Because of this ability to dispose of unsustainable mortgages, signs of the crisis brewing between 2001 and 2005 were hidden behind a “mask” of rising house prices. Using a statistical model to control for rising housing prices, Otto Van Hemert and I determined that default rates were increasing every year for six consecutive years before the crisis had shown any signs. This deterioration is observable now, with the help of hindsight and research findings, but it was also known to some extent to those who were securitizing subprime mortgages in those years. Securitizers seemed to have been adjusting mortgage interest rates to reflect this deterioration in loan quality. In short, lenders’ expectations of the increasing risk of massive defaults among subprime borrowers were forming for years before the crisis; most likely, it was not the crisis that was unexpected, it was its timing and magnitude.
Also, myth number 7 debunked shows that the low teaser rates were actually available in the prime market and not the subprime market which points to early research I found that said that defaults were happening just as frequently in the prime market as they were the subprime market.
Hybrid mortgages were available both in prime and subprime mortgage markets, but at significantly different terms. Those in the prime market offered significantly lower introductory fixed rates, known as “teaser rates,” compared to rates following the resets. People assumed that the initial rates for subprime loans were also just as low and they applied the same label to them—“teaser rates.” We need to understand, though, that the initial rates offered to subprime hybrid borrowers may have been lower than they most likely would have been for the same borrowers had they taken a fixed-rate subprime mortgage, but they were definitely not low in absolute terms.
The average subprime hybrid mortgage rates at origination were in the 7.3 – 9.7 percent range for the years 2001–2007, compared to average prime hybrid mortgage rates at origination of around 2–3 percent. The subprime figures are hardly “teaser rates.”
So, as usual, we have a much more complicated picture existing than most talking and blogging heads would be able to see. From this work, we see a crisis that had been building for years “feeding off the lending, securitization, leveraging, and housing booms”. This just gives more credence to the call for more regulation of the lending and securitization process. The demand for certain types of loans to be securitized should not be feeding into the market for the kinds of loans given to home buyers. I would be most interested to see what kind of pressure or incentives were given to mortgage originators to put folks into loans not based on the borrower characteristics, but the ability to package that loan for resale. This makes a good case for rewriting lending laws as well as writing laws to regulate the securitization process.