Subprime Mortgage Myths

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.

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