JUNE 2004

The Expansion of the Subprime
Mortgage Lending Market

In remarks before the Financial Services Roundtable's Annual Housing Policy Meeting last month, Federal Reserve Board Governor Edward M. Gramlich outlined the benefits and costs of subprime mortgage lending as well as the challenges facing the industry.

Governor Gramlich identified the evolution and growth of subprime mortgage lending as "...one of the key financial developments of the 1990s." He noted that "[s]ubprime lending can be defined simply as lending that involves elevated credit risk." That elevated credit risk derives from the weak credit history (usually defined as a Fair Isaac and Company (FICO) credit score less than 620) and/or the inability to repay financial obligations that characterize the typical subprime borrower as well as from the characteristics of the subprime mortgage such as high loan-to-value ratio and property attributes.

Regulatory change played an important role in the emergence of subprime mortgage lending. Gramlich pointed out that without such change, "[t]wo decades ago subprime borrowers would typically have been denied credit." The Depository Institutions Deregulatory and Monetary Control Act (1980) however, "...eliminated all usury controls on first-lien mortgage rates, permitting lenders to charge higher rates of interest to borrowers who pose elevated credit risk, including those with weaker or less certain credit histories." In turn, lenders entering and seeking profits in this market required tools to measure risk and set terms for higher risk loans which led to technological innovations such as improvements in credit scoring. Such innovations will lower costs in the subprime mortgage market and Fannie Mae and Freddie Mac are pursuing efforts to "...extend automatic underwriting to the subprime market."

Other federal actions cited by Gramlich as spurring the development of the subprime mortgage market include: the Community Reinvestment Act (1977) which "...gave banking institutions a strong incentive to make loans to low- and moderate-income borrowers or areas...; the Federal Housing Administration "...liberalized its rules for guaranteeing mortgages, increasing competition in the market and lowering interest rates faced by some subprime mortgage borrowers."; and Fannie Mae and Freddie Mac "...sought to meet their federally mandated affordable housing goals by expanding into the prime and lower-risk segment of the subprime mortgage market."

Gramlich outlined the data illustrating the dramatic growth in subprime mortgage lending over just the past nine years. Subprime mortgage loan originations increased at an annual average rate of 25 percent per year from 1994 to 2003 and the subprime share of annual originations almost doubled. The expansion of the mortgage lending market has resulted in an overall increase in homeownership rates from 64 percent to over 68 percent—an increase of more than nine million households over the 1994 to 2003 period. More than half of the gain is accounted for by minority households. Homeownership rates have also improved "... on both sides of the income distribution."

Accompanying the rise in credit and homeownership opportunities that subprime lending affords are "...elevated rates of foreclosure and of the incidence of households seriously delinquent [more than ninety days past due] on their mortgages." Serious delinquency rates for the prime market measure about 1 percent while those for the subprime market are just over 7 percent on mortgages outstanding at the end of 2003. Subprime mortgages also experience higher 30-to-60-day delinquency rates than prime mortgages. While "...[t]he rates of serious delinquencies and near-serious delinquencies do raise important warning flags and should inspire renewed efforts to prevent foreclosures, ...they do not seem high enough to challenge the overall positive assessment." Gramlich remarked that "...[e]ven further social benefits would result if various institutions could agree on and implement changes that would lower foreclosures." Such changes include "...data analysis (to determine the source of foreclosure...), lending counseling, and alternative sources of credit."

While "[m]any subprime lenders operate under the highest lending standards," Gramlich noted that "...fraud, abuse, and predatory lending problems have also been a troublesome characteristic of the subprime market." Gramlich suggested that careful compliance examination is the best defense against predatory lending and that all of the players in the subprime market are or could be made subject to such scrutiny: Commercial banks, thrifts, and subsidiaries of banks represent 45 percent of subprime mortgage loans originated in 2002 and undergo compliance exams every three years; affiliates of financial holding companies (accounting for 43 percent of subprime mortgage loans in 2002) could be made subject to regular compliance exams; and independent mortgage companies (covering 12 percent of 2002 subprime mortgage loans) are subject to Federal Trade Commission enforcement measures.

Ensuring that continued growth in subprime mortgage lending will generate social benefits leaves challenges for all of the participants in the subprime market: How can lenders expand opportunities for extending prime and subprime mortgage credit while preventing new delinquencies and foreclosures?; How can Fannie Mae and Freddie Mac devise and implement their loan purchase standards (e.g., disclosure requirements, practice limitations, borrower classifications) in such a way as to protect borrowers without limiting lending activity?; and how can the Federal Reserve Board take the data collection and compliance efforts already in place for banks and financial holding companies and promote them for independent mortgage companies that are not subject to regular/routine monitoring?

In several cities and states, local lawmakers have taken matters into their own hands and enacted anti-predatory lending laws. Standard & Poor's (S&P) issued a report last month that evaluated (for ten jurisdictions that had enacted anti-predatory lending laws prior to January 2003) "...the impact the law may have on the availability of funds to pay investors in its rated securities." Those loans subject to anti-predatory lending laws that S&P considered risky for investors (due to litigation liability) will require "credit enhancement" in order for the loans to be included in securitized pools. Donald Lampe, an attorney with Womble Carlyle Sandridge & Rice in Greensboro, NC commented that "S&P does not want to get into policy..." and noted that "[t]his is a more subtle way of saying that high-cost and certain other loan types, if they show up in securitization pools, will not be welcome." In its press release accompanying its review, S&P noted that it "...recognizes that its credit enhancement requirements may affect the economics of securitizing loans subject to this additional credit enhancement. S&P published the maximum damages that would accompany violations of the anti-predatory lending laws. However, market participants should note that the additional credit enhancement requirement will be applied primarily to high cost loans that have historically not been a large component of Standard & Poor's rated transactions. As performance and loss information for the loans subject to additional credit enhancements develops, Standard & Poor's will adjust its criteria as appropriate....Standard and Poor's will continue to publish its criteria to keep market participants informed of any new approaches in this area."

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