Origins of the Subprime Mortgage Turmoil, again

According to Ben Bernanke;

Over the past quarter century, advances in information technology, the development of credit-scoring techniques, and the emergence of a large secondary market, among other factors, have significantly increased access to mortgage credit. From 1994 to 2006, subprime lending increased from an estimated $35 billion, or 4.5 percent of all one-to-four family mortgage originations, to $600 billion, or 20 percent of originations (Inside Mortgage Finance, 2007). Responsible subprime lending expanded credit to borrowers with imperfect or limited credit histories. More renters became homeowners than would have otherwise. Though few subprime mortgages are being written today, I believe responsible subprime lending has been helpful, and at some point will be again, in fostering sustainable homeownership.

However, far too much of the lending in recent years was neither responsible nor prudent. The terms of some subprime mortgages permitted homebuyers and investors to purchase properties beyond their means, often with little or no equity. In addition, abusive, unfair, or deceptive lending practices led some borrowers into mortgages that they would not have chosen knowingly.

The current crisis has many roots. The drop in home prices in many once-hot markets is among the most significant. In a recent survey, nearly 30 percent of homeowners reported that their houses decreased in value over the past year.2 The decline in home equity makes it more difficult for struggling homeowners to refinance and reduces the financial incentive of stressed borrowers to remain in their homes. Mortgage performance data show a strong correlation between adverse house price changes and subsequent increases in mortgage delinquency and foreclosure (Avery, Brevoort, and Canner, 2007; Gerardi, Shapiro, and Willen, 2007). Investors who purchased homes in the hope of price appreciation seem particularly likely to walk away from "underwater" mortgages. Indeed, the role of investors in the housing market has increased markedly over time. According to data collected under the Home Mortgage Disclosure Act (HMDA), lending to non-owner-occupants has risen from about 5 percent of the home-purchase loans in the mid-1990s to about 17 percent of all purchases in 2005 and 2006 (Avery, Brevoort, and Canner, 2007). Mortgage delinquencies are also tied to local economic conditions; notably, several midwestern states struggling with job losses and slow income growth have seen increased delinquencies.

The deterioration in underwriting standards that appears to have begun in late 2005 is another important factor underlying the current crisis. A large share of subprime loans that were originated during this time featured high combined loan-to-value ratios and, in some cases, layers of additional risk factors, such as a lack of full documentation or the acceptance of very high debt-to-income ratios. In 2006, for example, the HMDA data suggest that nearly 40 percent of higher-priced home-purchase loans involved a piggy-back loan or second mortgage.3 Indeed, many defaults are occurring within the first few months of origination, well before payment resets occur on subprime ARM products.

Much of the weakening in underwriting standards appears to have happened outside of institutions regulated by the federal banking agencies. The HMDA data for 2006 show that more than 45 percent of high-cost first mortgages were originated by independent mortgage companies, which are institutions that are not regulated by the federal banking agencies and that sell almost all of the mortgages they originate. In this instance, this originate-to-distribute model appears to have contributed to the breakdown in underwriting standards, as lenders often found themselves able to pass on the credit risk without much resistance from the ultimate investors. For a number of years, rapid increases in house prices effectively insulated lenders and investors from the effects of weaker underwriting, providing false comfort.

Another concern is the substantial number of borrowers with subprime ARMs whose interest rates are scheduled to reset upward--about 1.5 million in 2008.4 The problem posed by resets is serious, but it may be mitigated somewhat by lower short-term interest rates and by the efforts of servicers, including those working with the Hope Now Alliance, to find solutions for borrowers facing resets, including interest-rate freezes (Hope Now Alliance Servicers, 2008). In addition, the FHASecure plan, which the Federal Housing Administration (FHA) announced late last summer, offers qualified borrowers who are delinquent because of an interest rate reset and who have some equity in the home the opportunity to refinance into an FHA-insured mortgage. Recently, the Congress and Administration temporarily increased the maximum loan value eligible for FHA insurance, which will allow more borrowers access to this program.

The current high rate of delinquencies and foreclosures is not confined to the subprime market. In 2007, about 45 percent of foreclosures were on prime, near-prime, or government-backed mortgages. Across market segments, delinquencies are rising fastest on the more-complex loans originated over the past few years. In part, that trend seems to be due to the fact that such loans were made to borrowers in weaker financial condition. In some cases, borrowers may not have fully understood the details of their loans, including the potential for large payment increases.