The Evolution Of The Subprime Mortgage Market
The Evolution of the Subprime Mortgage MarketSouphala Chomsisengphet and Anthony Pennington-CrossThis 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.INTRODUCTION AND MOTIVATIONHomeownership 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 standard (prime) mortgage market have greater accessto credit in the subprime market. Two of the majorbenefits of this type of lending, then, are theincreased numbers of homeowners and the opportunity for these homeowners to create wealth.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 requirements 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 mortgage in the past.1 In fact, subprime lending is most1See Hillier (2003) for a thorough discussion of the practice of “redlining” 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 ofComptroller 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.F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E WJ A N UA RY / F E B R UA RY200631
Chomsisengphet and Pennington-Crossprevalent in neighborhoods with high concentrations of minorities and weaker economic conditions (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 Association of America (MBAA) reports that subprimeloans in the third quarter of 2002 had a delinquency rate 51/2 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 homeowners (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 addition, any concentration of foreclosed property canpotentially adversely impact the value of propertyin the neighborhood as a whole.Traditionally, the mortgage market set minimum 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 riskbased pricing. The success of the subprime marketwill in part determine how fully the mortgagemarket eventually incorporates pure price rationing (i.e., risk-based prices for each borrower).This paper provides basic information about32J A N UA RY / F E B R UA RY2006subprime 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 mortgage 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 subprime market (A– grade loans). Furthermore,lenders of subprime loans have increased theiruse of mechanisms such as prepayment penalties 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 subprime 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, includingborrower 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. TheF E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
Chomsisengphet and Pennington-CrossFigure 1Interest RatesInterest Rate at Origination12SubprimeSubprime 220032004NOTE: 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.Figure 2Foreclosures In ProgressRate Normalized to 1 in 8199920002001200220032004NOTE: 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.F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E WJ A N UA RY / F E B R UA RY200633
Chomsisengphet and Pennington-CrossTable 1Underwriting and Loan GradesCredit historyPremier PlusPremierA–BCC–0 x 30 x 121 x 30 x 122 x 30 x 121 x 60 x 121 x 90 x 122 x 90 x 12Foreclosures 36 months 36 months 36 months 24 months 12 months 1 dayBankruptcy, Chapter 7Discharged 36 monthsDischarged 36 monthsDischarged 36 monthsDischarged 24 monthsDischarged 12 monthsDischargedBankruptcy, Chapter 13Discharged 24 monthsDischarged 24 monthsDischarged 24 monthsDischarged 18 monthsFiled 12 monthsPay50%50%50%50%50%50%Mortgage delinquencyin daysDebt ratioSOURCE: Countrywide, downloaded from www.cwbc.com on 2/11/05.prime interest rate is collected from the FreddieMac Primary Mortgage Market Survey. The subprime interest rate is the average 30-year fixedrate at origination as calculated from theLoanPerformance data set. The difference betweenthe two in each month is defined as the subprimepremium. The premium charged to a subprimeborrower is typically around 2 percentage points.It increases a little when rates are higher anddecreases a little when rates are lower.From the lender’s perspective, the cost of asubprime loan is driven by the loan’s terminationprofile.2 The MBAA reports (through the MBAAdelinquency survey) that 4.48 percent of subprimeand 0.42 percent of prime fixed-rate loans werein foreclosure during the third quarter of 2004.According to LoanPerformance data, 1.55 percentof fixed-rate loans were in foreclosure during thesame period. (See the following section “Evolutionof Subprime Lending” for more details on thedifferences between these two data sources.)Figure 2 depicts the prime and subprime loansin foreclosure from 1998 to 2004. For comparison,the rates are all normalized to 1 in the first quarterof 1998 and only fixed-rate loans are included.The figure shows that foreclosures on primeloans declined slightly from 1998 through thethird quarter of 2004. In contrast, both measuresof subprime loan performance showed substan2The termination profile determines the likelihood that the borrowerwill either prepay or default on the loan.34J A N UA RY / F E B R UA RY2006tial increases. For example, from the beginningof the sample to their peaks, the MBAA measure increased nearly fourfold and theLoanPerformance measure increased threefold.Both measures have been declining since 2003.These results show that the performance and termination profiles for subprime loans are muchdifferent from those for prime loans, and afterthe 2001 recession it took nearly two years forforeclosure rates to start declining in the subprime market. It is also important to note that,after the recession, the labor market weakenedbut the housing market continued to thrive (highvolume with steady and increasing prices). Therefore, there was little or no equity erosion causedby price fluctuations during the recession. Itremains to be seen how subprime loans wouldperform if house prices declined while unemployment rates increased.The rate sheets and underwriting matricesfrom Countrywide Home Loans, Inc. (downloadfrom www.cwbc.com on 2/11/05), a leading lenderand servicer of prime and subprime loans, providesome details typically used to determine whattype of loan application meets subprime underwriting standards.Countrywide reports six levels, or loangrades, in its B&C lending rate sheet: Premier Plus,Premier, A–, B, C, and C–. The loan grade is determined by the applicant’s mortgage or rent paymenthistory, bankruptcies, and total debt-to-incomeratio. Table 1 provides a summary of the fourF E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
Chomsisengphet and Pennington-CrossTable 2Underwriting and Interest RatesLTVLoan gradePremier PlusPremierA–BCCredit .407.905008.109.80680680680660C–680660600NOTE: The first three years are at a fixed interest rate, and there is a three-year prepayment penalty.SOURCE: Countrywide California B&C Rate Sheet, downloaded from www.cwbc.com on 2/11/05.underwriting requirements used to determinethe loan grade. For example, to qualify for thePremier Plus grade, the applicant may have hadno mortgage payment 30 days or more delinquentin the past year (0 x 30 x 12). The requirement isF E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E Wslowly relaxed for each loan grade: the Premiergrade allows one payment to be 30-days delinquent; the A– grade allows two payments to be30-days delinquent; the B grade allows one payment to be 60-days delinquent; the C grade allowsJ A N UA RY / F E B R UA RY200635
Chomsisengphet and Pennington-Crossone payment to be 90-days delinquent; and theC– grade allows two payments to be 90-daysdelinquent. The requirements for foreclosuresare also reduced for the lower loan grades. Forexample, whereas the Premier Plus grade stipulates no foreclosures in the past 36 months, theC grade stipulates no foreclosures only in the past12 months, and the C– grade stipulates no activeforeclosures. For most loan grades, Chapter 7 andChapter 13 bankruptcies typically must have beendischarged at least a year before application;however, the lowest grade, C–, requires only thatChapter 7 bankruptcies have been dischargedand Chapter 13 bankruptcies at least be in repayment. However, all loan grades require at least a50 percent ratio between monthly debt servicingcosts (which includes all outstanding debts) andmonthly income.Loan grade alone does not determine the costof borrowing (that is, the interest rate on the loan).Table 2 provides a matrix of credit scores andloan-to-value (LTV) ratio requirements that determine pricing of the mortgage within each loangrade for a 30-year loan with a 3-year fixed interestrate and a 3-year prepayment penalty. For example, loans in the Premier Plus grade with creditscores above 680 and down payments of 40 percent or more would pay interest rates of 5.65percentage points, according to the Countrywiderate sheet for California. As the down paymentgets smaller (as LTV goes up), the interest rateincreases. For example, an applicant with thesame credit score and a 100 percent LTV will becharged a 7.50 interest rate. But, note that theinterest rate is fairly stable until the down payment drops below 10 percent. At this point thelender begins to worry about possible negativeequity positions in the near future due to appraisalerror or price depreciation.It is the combination of smaller down payments and lower credit scores that lead to thehighest interest rates. In addition, applicants inlower loan grades tend to pay higher interest ratesthan similar applicants in a higher loan grade.This extra charge reflects the marginal risk associated with missed mortgage payments, foreclosures, or bankruptcies in the past. The highest rate36J A N UA RY / F E B R UA RY2006quoted is 9.8 percentage points for a C– grade loanwith the lowest credit score and a 30 percent downpayment.The range of interest rates charged indicatesthat the subprime mortgage market actively pricediscriminates (that is, it uses risk-based pricing)on the basis of multiple factors: delinquent payments, foreclosures, bankruptcies, debt ratios,credit scores, and LTV ratios. In addition, stipulations are made that reflect risks associated withthe loan grade and include any prepayment penalties, the length of the loan, the flexibility of theinterest rate (adjustable, fixed, or hybrid), the lienposition, the property type, and other factors.The lower the grade or credit score, thelarger the down payment requirement. Thisrequirement is imposed because loss severitiesare strongly tied to the amount of equity in thehome (Pennington-Cross, forthcoming) and priceappreciation patterns.As shown in Table 2, not all combinations ofdown payments and credit scores are availableto the applicant. For example, Countrywide doesnot provide an interest rate for A– grade loanswith no down payment (LTV 100 percent).Therefore, an applicant qualifying for grade A–but having no down payment must be rejected.As a result, subprime lending rations creditthrough a mixture of risk-based pricing (pricerationing) and minimum down payment requirements, given other risk characteristics (nonpricerationing).In summary, in its simplest form, what makesa loan subprime is the existence of a premiumabove the prevailing prime market rate that aborrower must pay. In addition, this premiumvaries over time, which is based on the expectedrisks of borrower failure as a homeowner anddefault on the mortgage.A BRIEF HISTORY OF SUBPRIMELENDINGIt was not until the mid- to late 1990s that thestrong growth of the subprime mortgage marketgained national attention. Immergluck and Wiles(1999) reported that more than half of subprimeF E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W
Chomsisengphet and Pennington-CrossTable 3Total Originations—Consolidation and GrowthYearTotal B&Coriginations(billions)Top 25 B&Coriginations(billions)Top 25market shareof B&CTotaloriginationsB&Cmarket shareof total1995 65.0 25.539.3% 639.410.2%1996 96.8 45.346.8% 785.312.3%1997 124.5 75.160.3% 859.114.5%1998 150.0 94.362.9% 1,450.010.3%1999 160.0 105.666.0% 1,310.012.2%2000 138.0 102.274.1% 1,048.013.2%2001 173.3 126.873.2% 2,058.08.4%2002 213.0 187.688.1% 2,680.07.9%2003 332.0 310.193.4% 3,760.08.8%SOURCE: Inside B&C Lending. Individual firm data are from Inside B&C Lending and are generally based on security issuance orpreviously reported data.refinances3 originated in predominately AfricanAmerican census tracts, whereas only one tenthof prime refinances originated in predominatelyAfrican-American census tracts. Nichols,Pennington-Cross, and Yezer (2005) found thatcredit-constrained borrowers with substantialwealth are most likely to finance the purchase ofa home by using a subprime mortgage.The growth of subprime lending in the pastdecade has been quite dramatic. Using datareported by the magazine Inside B&C Lending,Table 3 reports that total subprime or B&C originations (loans) have grown from 65 billion in 1995to 332 billion in 2003. Despite this dramaticgrowth, the market share for subprime loans(referred to in the table as B&C) has dropped froma peak of 14.5 percent in 1997 to 8.8 percent in2003. During this period, homeowners refinancedexisting mortgages in surges as interest ratesdropped. Because subprim
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 with a price: At its simplest, subprime lending can be described as high-cost lending. Borrower cost associated with subprime lending is driven primarily by two factors .
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