Credit Risk and Mortgage Lending Who Uses Subprime and Why?

Title: Credit Risk and Mortgage Lending Who Uses Subprime and Why?

Date: 10/1/2000

Author(s): Anthony Pennington-Cross, Anthony Yezer, and Joseph Nichols

Executive Summary:

Media coverage of predatory lending has exploded in recent years. Specific instances of abusive practices by some subprime mortgage lenders have provided juicy fodder for congressional hearings and legislative activity, as well as calls for extensive federal, state, and local regulatory activity. Federal regulators such as the Office of Thrift and Supervision, the Federal Reserve Board, and the Department of Housing and Urban Development are examining current regulatory regimes to see if new rules or enforcement actions are necessary. Well-known lenders have recently been accused of violating various consumer protection laws, and face litigation and protests by community activists - not to mention unwanted media attention. Potential legal damages, as well as loss of business and reputation, are immense.
Often driving this attention is the argument that the subprime market - often incorrectly equated with predatory lending - has grown explosively in recent years. This cited growth, however, is in large part a statistical artifact of increased Home Mortgage Disclosure Act reporting by covered institutions because of market evolution such as acquisitions, expansion, and changes in reporting requirements. Effective public policy, sound business practice, and accurate public opinion must be better informed on basic questions such as default prepayment, and claims history of subprime loans.

In this context, Pennington-Cross, Yezer, and Nichols make an important contribution by examining the simple question of how and when households use the subprime market for home-purchase loans, specifically examining fixed-rate mortgages below the FHA limit. They find those who show higher-risk profiles are more likely to use subprime and Federal Housing Administration (FHA) lending.

Another important finding is that FHA dominates the market for low-down payment mortgages (i.e., low-wealth borrowers). In contrast, subprime lenders lend to households having enough wealth for down payments to compensate for other deficiencies in their mortgage application. These deficiencies typically include problems with credit history, such as bankruptcies, legal claims or judgements, high non-real estate debt, and excessive delinquencies.

Thus, subprime lending for home-purchase loans appears to be less concentrated in underserved areas or with low-income borrowers, and more consistent with the income distribution of the overall segment of the mortgage market examined in this study. In contrast to much public debate and comment, these findings suggest a properly functioning market.

However, unexplained differences remain. For instance, Black and Asian borrowers have a higher probability (0.8 to 1.6 percentage points) of using the subprime market. This is a big increase on a relatively small base; only 2.5 percent of the borrowers in the sample borrowed from the subprime market. These differences could be because of technical issues such as the econometric specification. Also, this study suffers from the same problem that many studies examining loan decisions face; it is extremely difficult, if not impossible, to include all the variables that go into a loan decision. Thus, a practical consequence is that this study's model may predict a relatively higher probability of subprime use for a person or group than might be expected, all other factors equal. Data used in the study may suggest, for instance, a prime market candidate, based on income, while the actual household may have secured a no-documentation loan available only in the subprime market.

Nevertheless, these unexplained spreads may indicate that borrowers may not be consistently or appropriately assigned the right mortgage by the market. Various interpretations are typically offered for such spreads. For instance, some argue inappropriate downstream referrals (prime to subprime) may be more likely than appropriate upstream referrals (subprime to prime). These spreads may also reflect a lack of consumer sophistication or preferences for certain types of loans or lending institutions. Clearly, given legitimate concerns for fair lending, these differences cannot be lightly dismissed, and require further exploration.

However, focusing on predatory lending obscures a critical but unanswered question about legitimate subprime lending: What rate of default is too high? For instance, according to the Mortgage Information Corporation, a financial database firm, the rate that loans become "seriously" delinquent rises from 0.53 percent for prime mortgages to 6.8 percent for B rated loans and up to 20.5 percent for D rated loans. Even if the consequences of default were fairly trivial, one out of every five households failing in homeownership cannot be good for the family, the neighborhood, or the economy.

Lastly, to shed its stigma and gain broader recognition of the legitimate service provided by the subprime market, more information about subprime lending must reach consumers and public policy makers. For instance, why do subprime lenders not advertise more, and why do local newspapers not publish, as they do prime lenders, current interest rates and fees for local subprime lending institutions?

Information in the hands of the consumer and transparent transactions are the bedrock of a well functioning market economy, and increasingly a dominant driver of the traditional mortgage market. Meeting the information challenge can help to chart a brighter future for this important and growing part of the mortgage market.