Subprime Mortgages: Primer on Current Lending and Foreclosure Issues

Subprime Mortgages: Primer on Current Lending
and Foreclosure Issues
March 19, 2007
Edward Vincent Murphy
Analyst in Financial Institutions
Government and Finance Division

Subprime Mortgages: Primer on Current Lending and
Foreclosure Issues
Summary
Subprime mortgages are loans extended to borrowers with weak credit profiles.
Subprime mortgages entail higher risk of delinquency and default. Recent increases
in subprime borrower foreclosures and lender bankruptcies have prompted concerns
that some lenders’ underwriting guidelines are too loose and that some borrowers
may not have fully understood the risks of the mortgage products they chose.
Regulatory agencies are revisiting the guidance they provide lenders and are
reevaluating required disclosures to consumers. In addition, Congress is holding
hearings on the subject and may consider consumer protection legislation.
Subprime foreclosures have reached the highs of the 2000-2001 recession but
delinquency rates are not the same across mortgage features. The adjustable interest
rate (ARM) feature is currently associated with higher delinquency rates than
comparable fixed rate loans. However, the delinquency rate of loans with the
negative amortization (NegAm) feature has remained below 1%, the range normally
associated with less risky loans. NegAm is a loan that allows a monthly payment less
than the current interest on the loan with the remaining interest added to the
principal, thus increasing the loan balance.
Financial regulators issued a guidance for alternative mortgage products in
October 2006 and issued a proposed statement for subprime lending in March 2007.
The guidances require that consumers be given plain-language explanations of the
risks of their mortgages. Borrowers must be qualified for mortgage loans based on
the ability to repay the loan, not based on speculation about future increases in the
value of the real estate collateral. The proposed guidance also seeks to limit payment
shock and prepayment penalties. Policymakers are faced with the challenge of
balancing the benefits of access to credit against the costs of potential foreclosures.
This report will be updated in the event of significant regulatory or legislative
change.

Contents
Background ......................................................1
The Subprime Market and Alternative Mortgages.........................2
Growth, Foreclosures, and Risk in Subprime Mortgages...................3
Stress on Subprime Lenders..........................................6
Banking Agency Guidance...........................................7
Policy Considerations..............................................9
List of Figures
Figure 1. Prime and Subprime Loans in Foreclosure, 1998-2006............4
Figure 2. Delinquency Rate of Subprime Mortgages by Feature.............5
Figure 3. ABX Index of BBB- Rated Mortgage Derivatives................7

Subprime Mortgages: Primer on Current
Lending and Foreclosure Issues
Background
Subprime mortgage lending can benefit consumers by allowing greater access
to credit, and thus homeownership, but can also impose costs on consumers through
defaults and foreclosures. Subprime refers to people who have no credit history,
have a blemished credit record, and/or have a weak debt-service-to-income ratio. A
generation ago, subprime loan applicants were generally denied credit and neither
enjoyed homeownership nor risked default. Policymakers evaluating subprime
lending issues will be called on to consider the benefits of increased access to credit
markets which can lead to homeownership as well as the costs of increased debt
burdens and potential foreclosure. To that end, this report describes the subprime
market, presents delinquency and foreclosure data, and summarizes banking agency
guidance on subprime lending.
The rise of risk-based pricing encouraged growth of the subprime market during¹
the mid-1990s. For example, the number of subprime refinance loans increased
nearly tenfold between 1993 and 1998.² Subprime loans increased from an estimated³
5% of the mortgage market in 1994 to as much as 20% in 2005. After retreating
during the recession of 1999-2001, subprime lending expanded rapidly during 2002-

2005. In 2006, the housing market slowed and there was a rise in late mortgage

¹ Risk-based pricing refers to assessing a borrower’s risk and then charging higher-risk
borrowers a higher interest rate rather than simply refusing to qualify them for a loan. In
contrast, pool-based pricing accepts a range of borrowers into a pool which is charged the
same rate based on the average credit quality of the pool. Borrowers outside the pool are
simply denied credit.
² “Unequal Burden in New York: Income and Racial Disparities in Subprime Lending,”
Department of Housing and Urban Development (HUD), May 2000, p.1. The study cites
the Home Mortgage Disclosure Act (HMDA) database as reporting 80,000 subprime loans
in 1993 and 790,000 in 1998.
³ Robert Avery et al., “Higher-Priced Home Lending and the 2005 HMDA Data,” Federal
Reserve Bulletin, September, 2006 (rev.), p. A125. There is no single accepted source for
subprime market share. The Federal Reserve collects loan information through the Home
Mortgage Disclosure Act (HMDA), which does not currently require lenders to report a
borrower’s credit score and only requires interest rate information if the rate is more than

3% above a comparable Treasury rate. The proportion of loans that exceed HMDA’s 3%

threshold, and are thus considered high cost, is sensitive to changes in the proportion of
loans that are adjustable rate and to the difference between short-term and long-term interest
rates. Alternatively, the Department of Housing and Urban Development maintains a list of
lenders who specialize in loans to consumers with weaker credit. The market share of these
lenders can vary significantly over time. Private financial consultants with access to more
detailed lender loan information provide a third set of estimates.

payments and foreclosures. The rise in delinquencies and foreclosures continues to
be more severe in the subprime market than the prime market but both rates are
growing. Several prominent subprime lenders are experiencing financial difficulties,
including the recent bankruptcy of Ownit and investigations into New Century.
Potential negative consequences for consumers, banks, and financial markets have
drawn renewed attention to government policies related to subprime lending.
Government policies play a role at each stage of the mortgage lending process.
When a borrower takes out a mortgage loan, the Truth in Lending Act (TILA) and
the Home Ownership Equity Protection Act (HOEPA) provide rules for disclosure
and limitations on the terms of certain high cost loans. When lenders originate loans,
the regulatory agencies of the Federal Financial Institutions Examinations Council
(FFIEC) supervise their portfolios to ensure safe and sound banking practices.⁴
When lenders sell some of their loans to secondary markets through the government
sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, the Office of Federal
Housing Enterprise Oversight (OFHEO) supervises the GSEs for safety and
soundness and the Department of Housing and Urban Development (HUD) regulates
the GSE’s charter compliance. When investors purchase mortgage-backed securities
(MBS) issued by the GSEs or their competitors, the Securities and Exchange
Commission (SEC) enforces the anti-fraud provisions of the securities laws.
Government policies designed to aid lower-income consumers achieve
homeownership may have contributed to the expansion of subprime lending. For
example, the Community Reinvestment Act (CRA) encourages lenders to provide
loans in the poorer areas of their market where subprime borrowers are more likely
to reside. Similarly, increases in HUD’s Affordable Housing Goals encourage the
GSEs to expand their purchases of loans originated from lower-income and minority
borrowers who are more likely to be subprime. Federal Housing Administration
(FHA) slowness to adopt some of the nontraditional mortgage products that became
popular when house prices were rising rapidly may have resulted in some FHA-
eligible borrowers turning to subprime lenders.
The Subprime Market and Alternative Mortgages
Generally, subprime mortgages are defined in terms of the credit bureau risk
score (FICO) of the borrower.⁵ Other credit imperfections, however, can also cause
borrowers to be categorized as subprime for a particular loan. For example, the
addition of the mortgage loan might increase the borrower’s debt-to-income level
above traditionally prudent thresholds. Generally, bank supervisors look for one or

⁴ The FFIEC includes the Federal Reserve Board (FRB), the Federal Deposit Insurance
Corporation (FDIC), The Office of Thrift Supervision (OTS), the Office of the Comptroller
of the Currency (OCC), and the National Credit Union Administration (NCUA).
⁵ A FICO score is an estimate of a borrowers creditworthiness provided by credit rating
agencies that monitor consumer payment histories. The term comes from the company, Fair
Isaacs, that originated the score and continues to provide it to lenders.

more of the following credit-risk characteristics when deciding to label a loan
subprime:⁶
^!Recent payment delinquencies (30-day or 60-day depending on
recency)
^!Judgment, foreclosure, repossession, or charge-off within prior two
years
^!Bankruptcy in the last five years
^!Relatively high default probability (FICO below 660 or similar
measure)
^!Limited ability to cover living expenses after debts (debt-service-to-
income ratio of 50% or more)
Subprime loans are disproportionately used by the elderly and members of
minority groups. The elderly are more likely to own a home and to have accumulated
significant equity and therefore are more likely to qualify for a refinance loan despite,
perhaps, having imperfect credit. Minorities, on average, have lower incomes and
therefore are often more likely to have credit blemishes. In addition, there is some
evidence that minorities who could qualify for cheaper prime loans are sometimes
borrowing in the more expensive subprime market.⁷
In recent years, subprime borrowers increasingly used alternative mortgage
products that had previously been used primarily by sophisticated investors. Interest
only (I-O) mortgages provide an introductory period during which monthly payments
cover only the loan interest. After the introductory period, loan payments reset to a
higher amount to also cover the loan’s principal. Negative amortizing mortgages
(NegAms) allow borrowers to pay less than current interest due and result in a higher
loan balance and higher future payments. In contrast to fixed rate mortgages (FRM),
which have fixed interest rates and constant monthly payments, adjustable rate
mortgages (ARMs) reset the interest rate with changes in market interest rates and
therefore can result in higher or lower monthly payments depending on market
conditions. Because alternative mortgage products allow monthly payments to rise,
some policymakers are concerned that subprime borrowers in particular may not have
fully understood the risks associated with non-traditional features.
Growth, Foreclosures, and Risk
in Subprime Mortgages
Expansion of the subprime market may have benefited some consumers by
improving access to credit and facilitating homeownership. The timing of the growth
of the subprime market corresponds to growth in homeownership. The U.S.

⁶ “Subprime Lending (Risk Management and Internal Controls),” Bank Holding Company
(BHC) Supervision Manual, Section 2128.08, Dec. 2002, pp1-2.
⁷ Unequal Burden: Income and Racial Disparities in Subprime Lending in America, HUD,

2000.

homeownership rate increased from 64.1% in 1993 to 68.9% in 2005.⁸
Homeownership among minority groups increased at a faster rate, from 42.4% in
1993 to 51.3% in 2005. Recall that subprime lending is more prevalent in minority
communities. The homeownership gap between white-non-hispanics and all-
minorities dropped from 27.8 percentage points in 1993 to 24.5 percentage points in

2005.

Expansion of the subprime market may have increased the costs associated with
greater debt burdens. Subprime foreclosures increased faster than prime foreclosures
during the 2000-2001 recession and are again rising faster than prime foreclosures
in the current housing slowdown. Figure 1 presents data from the Mortgage Bankers
Association mortgage delinquency survey. Subprime loans in this sample are several
times more likely to go into foreclosure and are far more sensitive to the credit cycle
than prime loans. Figure 1 shows that less than 1% of prime loans were in
foreclosure during 1998-2006. In contrast, at least 3% of subprime loans were
generally in foreclosure. During the 2000-2001 recession, subprime foreclosures
reached almost 10%. In the current housing downturn, subprime foreclosures are
again rising rapidly.
Although higher subprime foreclosures confirm that subprime loans are riskier
than prime loans, the evidence for alternative mortgage products depends on the
particular feature. Figure 2 shows that the adjustable rate feature appears to be
Figure 1. Prime and Subprime Loans in Foreclosure, 1998-2006

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⁸ U.S. Department of Commerce, Bureau of the Census. The year 1993 is chosen as the
beginning point both because Census data reflect a changed weighting procedure in that year
and because the subprime market grew rapidly during 1993-1998.

under significant stress for both interest-only loans and fully amortizing loans.⁹ Loan
Performance, a financial consulting firm, has found that among subprime loans,
adjustable rate products appear to have increased their delinquency rate faster than
fixed rate products since 2005.¹⁰ During the period Loan Performance studied, the
60-day delinquency rate for subprime fixed rate mortgages remained close to 9%, but
the 60-day delinquency rate for subprime adjustable rate mortgages rose from under

2% during the summer of 2004 to over 14% in November 2006.

Figure 2. Delinquency Rate of Subprime Mortgages by Feature

The 60-day delinquency rate for negative amortizing (NegAm) loans is rising
but remains relatively low. NegAm loans give the borrower the option of paying less
than the interest owed in any month and therefore can increase the loan balance. In
the sample analyzed by Loan Performance, most NegAm ARMs originated during
2004-2006 have increased their balance but the delinquency rate for these products
has not risen as fast as subprime delinquency rates. The 60-day delinquency rate for
all NegAm ARMs originated in 2006 remained below 1%, but the 60-day
delinquency rate for subprime ARMs originated in 2006 exceeds 8%.¹¹
⁹ A fully amortizing loan pays off the loan balance using the traditional method of constant
monthly payments. An interest-only loan has an introductory period of lower payments
during which the monthly payments do not pay down the loan balance.
¹⁰ Loan Performance calculations cited in Economic Commentary, Fannie Mae, February 20,
2007, p.2. A 60-day delinquent loan is not yet a loan in foreclosure. Loan Performance’s
definition of subprime does not necessarily match the Mortgage Bankers Association survey.
¹¹ Loan Performance calculations cited in Economic Commentary, Fannie Mae, February 20,
(continued...)

Stress on Subprime Lenders
In addition to rising foreclosures among subprime borrowers, the slowdown in
the housing market has also challenged subprime lenders. Many subprime lenders
raise funds by selling their loans to investors in the secondary market and using the
proceeds to make new loans. These lenders can suffer significant hardship if
investors downgrade the value of subprime debt. For example, Ownit Mortgage
declared bankruptcy in December 2006, reportedly after it lost financing from Merrill¹²
Lynch and other investors. New Century is under investigation for accounting and
other improprieties connected to its subprime business. Several other lenders have
shut their doors or restricted their subprime lending.
Stress on subprime financing is not confined to just a few lenders. A key
indicator of investor estimation of the risk associated with funding loans through
secondary markets, the ABX index, declined suddenly and significantly for subprime
loans in February 2007 (see Figure 3). The ABX index is based on the cost of
hedging purchases of mortgage loans that are packaged into securities and sold to
investors in the secondary market.¹³ According to Markit, an independent provider
of data for derivatives trades, the price that investors were willing to pay for the
BBB- rated portion of the index (part of the subprime market) fell from just over
97% on January 19, 2007, to under 70% by February 26, 2007.¹⁴ The decline in the
ABX index reflects the reduced willingness of investors to accept the risks associated
with subprime loans. As a result, funds for additional subprime loans are decreasing.

¹¹ (...continued)
2007, p.2. Not all subprime loans are NegAm loans and not all NegAm loans are subprime
loans.
¹² Julie Creswell and Vikas Bajaj, “A Mortgage Crisis Begins to Spiral and Casualties
Mount,” New York Times, Mar. 5, 2007, p. C1.
¹³ Investors can use insurance and other financial instruments to reduce their exposure to the
risk that their investment will go sour. A traditional hedge occurs when someone
simultaneously invests in two instruments that move in opposite directions so that if one
goes bad, the other partially compensates. The ABX index is one measure of the price
investors are willing to pay to hedge mortgage backed securities.
¹⁴ Data provided by Markit Group, Limited. The company receives daily data contributions
from over 70 firms dealing in related securities. See [http://www.Markit.com]. A decline
in the index percentage represents an increase in the cost to hedge the investment.

Figure 3. ABX Index of BBB- Rated Mortgage Derivatives

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The safety and soundness of subprime lenders has been a concern for many
policymakers because some believe that disruptions in financial markets could have
wider effects on the economy. For example, some believe that banking disruptions
can make the business cycle more volatile. Federal responses to the Savings and
Loan Crisis in the 1980s may have been due in part to concerns for the larger
economy. The Federal Reserve itself was created because of a congressional
commission to study banking issues in the Panic of 1907. While disruptions in the
current subprime market do not rise to the level of historic banking panics, financial
regulatory agencies have made public their intention to closely watch the subprime
sector. The FFIEC agencies have issued new inter-agency guidance “to address
emerging issues and questions relating to certain subprime mortgage lending
pract i ces.”¹⁵
Banking Agency Guidance
Financial regulators have recognized the increased risks of subprime lending.
Rising subprime foreclosures during 2000 prompted the OCC to tighten oversight of
subprime lending programs in January 2001. “Institutions with significant subprime
lending activities will be subject to closer scrutiny to ensure that their programs have
¹⁵ “Proposed Statement on Subprime Mortgage Lending,” Federal Register, Vol 72, No. 45,
Mar. 8, 2007, p. 10533.

appropriate risk management controls and capital support.”¹⁶ The guidance covered
capital maintenance, standards for individual loan review by examiners,
documentation requirements for delinquent subprime accounts, and policies to curb
potentially abusive lending practices.
Since 2001, as mortgage markets have continued to evolve, and housing markets
have expanded, subprime lending has drawn renewed attention. In October 2006, the
lending regulators of the FFIEC issued guidance for alternative mortgage products.
The guidance reiterated that lenders must qualify loans based on the borrower’s
ability to repay the loan balance, not based on the value of the loan collateral in sale
or foreclosure. The October 2006 guidance also reminded lenders of Truth in
Lending Act requirements to explain payment terms in plain language in order to
curb abusive lending practices.
With subprime delinquencies and foreclosures mounting again, the FFIEC has
issued a new interagency guidance for comment. The proposed guidance “reiterates
many of the principles addressed in existing guidance relative to prudent risk
management practices and consumer protection laws.”¹⁷ Concerning risk
management, the proposed guidance states that predatory lending typically involves
at least one of (1) lending on collateral value rather than borrower ability to repay,
(2) inducing repeated refinances to charge high points and fees, or (3) using deceptive
marketing to conceal the true nature of the mortgage obligation. Concerning
consumer protection, the proposed guidance states that mortgage product descriptions
and advertisements should provide clear, detailed information on the costs, terms,
features, and risks of the loan to the borrower, including any payment shock or
prepayment penalty.
In the proposed guidance, the FFIEC asks for comments concerning restrictions
on planned refinances because “the structural evolution of subprime mortgage
lending in recent years has introduced some products that are intended at their outset
to be temporary credit accommodations in anticipation of early sale or refinancing,
rather than longer-term amortizing accounts.”¹⁸ Commentors are asked to address
the following:
^!Do planned subprime refinances always present inappropriate risks
that should be discouraged? If not, under what circumstances are
they appropriate?
^!Will the proposed guidance restrict existing subprime borrowers’
attempts to refinance and avoid payment shock?
^!Should restrictions on planned refinances apply beyond subprime
markets?

¹⁶ “Subprime Lending: Expanded Guidance for Subprime Lending Programs,” OCC 2001-6,
Jan. 31, 2001. This bulletin supplements OCC Bulletin 1999-15, “Subprime Lending, Risks
and Rewards.”
¹⁷ “Proposed Statement on Subprime Mortgage Lending,” Federal Register, Vol 72, No. 45,
Mar. 8, 2007, p. 10533.
¹⁸ “Proposed Statement on Subprime Mortgage Lending,” Federal Register, Vol 72, No. 45,
Mar. 8, 2007, p. 10533.

^!Should prepayment penalties be restricted to the introductory
period?
Policy Considerations
Subprime loans, which are extended to borrowers with weaker credit conditions,
have higher delinquency and foreclosure rates. Policies that facilitate subprime
lending have to balance the benefits of homeownership against the risks of increased
debt. More complex mortgage products may facilitate homeownership under some
conditions but may be more difficult for consumers to understand.¹⁹ Restrictions on
mortgage products may insulate credit-impaired borrowers from default risk but may
make it more difficult for these potential borrowers to own a home. Federal and state²⁰
authorities also protect consumers through anti-predatory lending initiatives. The
recent rise in subprime delinquencies illustrates the trade-off between encouraging
greater access to credit markets and risking increased defaults and foreclosures.
Policymakers decide the role of government agencies and government
sponsored enterprises (GSEs) in the subprime sector.²¹ Some argue that greater GSE
presence in the subprime market could help reduce instability in that market by
helping to standardize underwriting procedures. Raising the GSEs’ housing goals
may direct their programs to lower-income households but may increase the flow of
funds to risky mortgages.²² Reforming the loan programs of the Federal Housing
Administration (FHA) could provide lower-income borrowers with an alternative to
subprime lenders but may be less flexible in changing market conditions.²³ FHA
makes it easier for borrowers to obtain loans by insuring the loan payments. On the
other hand, some argue that granting FHA greater flexibility could increase the
amount of risky mortgages.

¹⁹ CRS Report RL33775, Alternative Mortgages: Risks to Consumers and Lenders in the
Current Housing Cycle, by Edward Vincent Murphy.
²⁰ CRS Report RL32784, Predatory Lending: A Comparison of State Laws to the Federal
Home Ownership and Equity Protection Act, by Kamilah M. Holder, Kate M. Manuel.
²¹ CRS Report RS22336, GSE Reform: A New Affordable Housing Fund, by N. Eric Weiss.
²² The GSE housing goals refer to the percentage of housing units financed by the GSEs’
loan purchases that must be for low income groups and underserved areas. The housing
goals are set by HUD.
²³ CRS Report RS20530, FHA Loan Insurance Program: An Overview, by Bruce E. Foote,
Meredith Peterson.