The Regulation of
Subprime Lending
Todd J. Zywicki
Professor of Law
George Mason University School of Law
Research Fellow, James Buchanan Center
Program on Politics, Philosophy, and Economics
Overview
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Understanding the Subprime Market
Benefits of Subprime Lending
Risks of Subprime Lending
Regulating the Subprime Market
Growth of Subprime Market
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1994-2005:
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Still, as of 2005:
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$35 billion => $600 billion
5% of all mortgage originations => 20%
33% of homes owned free and clear
57% traditional fixed-rate mortgages
10% ARMs
Very Young Market: Recent Turmoil on
Wall Street
What is “Subprime”?
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“Weak credit repayment history or
credit characteristics that indicate
reduced repayment capacity, such as
high debt-to-income ratios”
Low or No Doc: Have credit
characteristics of prime but can’t
provide full documentation of income
and assets (such as self-employed)
What is “Predatory Lending”?
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Asset-Based Lending: Making unaffordable loans based
on the assets of the borrower (collateral) rather than on
the borrower’s ability to repay
Loan Flipping: Inducing repeated refinancing in order to
charge high points and fees each time the loan is
refinanced
Fraud and deception: Inflating property appraisals,
doctoring loan docs, “bait and switch” terms, failure to
disclose
Excessive Fees: Often not disclosed thoroughly
Excessive Interest Rates Relative to Risk: “Steering”
borrowers to higher-rate loans
“Unfairly” Burdensome Prepayment Penalties
Balloon payments: Often combine low monthly payment
with inadequate disclosure of balloon
Challenge: Separating Risk-Based Pricing from Predation
Peculiarities of Subprime Market
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Higher Costs
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Prepayment Risk: Three times more common
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Underwriting
Servicing
Prepayment in Prime: changes in interest rates
Prepayment in Subprime: Improvement in FICO
Subprime twice as likely to prepay if no penalty
Documentation and Income
Historically Specialized Lenders
Use of Brokers
Questionable Characters: Lenders and Borrowers
Types of Subprime
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AA: No 60 day late credit cards, 1 thirty day late
mortgage or, No 60 day late
A-minus: missed one mortgage payment or two credit
card payments in last two years
Alt-A: similar credit histories by less documentation of
income or assets or unusual collateral characteristics
B: 4 30 day late mortgage (or 2 30 and 1 60), 0 60 day
late in past 12 months, 1 60 day late in past 24 months,
no foreclosure proceedings in last 24 months
C: 6x30, 1x60, 1x90 or 6x30, 2x 60, and 0x90
D: Exceeds C, Recent Bankruptcy
70% of subprime are A-minus or Alt-A
Basic Terms: Option One
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Grade (Option One Grade Names Differ)
FICO Score
Region
LTV (Sliding Scale, Min & Max Depending
on FICO Score)
Full Doc or Lite Doc
Based on 2 year Fixed, 2 year prepay
limitation, Single Family Home
Adjustments
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Fixed or Longer Fixed Period (3 year, 5 year
ARM)
40 or 50 year Amortization
Interest Only
No Documentation
Disposable Income
Cash Reserves
First Time Home Buyer
10% Downpayment
State Prepay Legal Prohibitions
Type of Property (Condo, Second Home)
Benefits of Subprime Growth
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Increased Home Ownership
Wealth Accumulation
Wealth Equality
Access to Alternative Credit
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
20
05
Home Ownership
Home Ownership Percentage
70
69
68
67
66
65
64
63
62
61
60
Change in Homeownership
Home Ownership by Race
75
70
65
White
60
Black
Hispanic
55
Asian
50
45
20
05
20
04
20
03
20
02
20
01
20
00
19
99
19
98
19
97
19
96
40
Wealth Accumulation
Median Wealth: Owners Versus Renters
200,000
180,000
160,000
140,000
120,000
100,000
80,000
60,000
40,000
20,000
0
Wealth Accumulation
Wealth By Age: Owners v. Renters
300,000
250,000
Owners Median
Wealth
Renters Median
Wealth
200,000
150,000
100,000
50,000
0
Under 35
35-64
65+
Wealth Accumulation
Wealth by Income
350,000
300,000
250,000
Under $20k Income
200,000
$20k-$50k Income
150,000
$50k+ Income
100,000
50,000
0
Owners Median Net Wealth
Renters Median Net Wealth
Wealth Equality by Race
Wealth By Race: Homeowners v. Renters
250,000
200,000
White Households
150,000
Black Households
100,000
Hispanic Households
50,000
0
Owners Median Net
Wealth
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Renters Median Net
Wealth
Differences between Owners and Renters within Races are much
larger than differences between races: White Households are about
2-1/2 wealthier than other races, but homeowners about 30 times
wealthier (black homeowners are 36.5 times wealthier than renters)
Wealth Accumulation
Share of Home Equity in Household Net Wealth (Median)
90.00%
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
77.30%
54.70%
41.60%
27.20%
All Households
Owners
Minority Owners
Owners with
Income < $20k
Wealth Equality
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Housing Wealth is more broadly
distributed than financial (stock) wealth.
White families have four times as much
stock wealth (median) as blacks and
hispanics but only twice as much home
equity wealth (median)
Housing and Rent Risk
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Todd Sinai and Nicholas S. Souleles,
“Owner-Occupied Housing As A Hedge
Against Rent Risk,” Q. J. Econ. (2005)
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Homeowners Balance Two Risks
Rent Risk (variation 2.9% per year):
Homeownership and housing prices higher where
rent price volatility rises
 Effect greatest when rent higher portion of income
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Asset Price Risk: Ownership higher where
time horizons longer
Homeownership and Credit
Financial Obligations Ratio
32
28
26
24
Renter FOR
22
Homeowner
FOR
20
18
16
14
12
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
Percentage of Income
30
Year
More Credit Options
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Renters have
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More Student Loan Debt
More Automobile Debt
More Credit Card Debt
Causes of Rising Ownership
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Federal Reserve Bank San Francisco (Nov.
3, 2006): “We find that… it is likely that
much of the increase is due to innovations
in the mortgage finance industry that may
have helped a large number of households
buy homes more easily than they could
have a decade ago.”
Risks of Subprime: More Debt
Debt Service Ratio by Type of Debt: 1980-2006
0.12
0.1
Nonrevolving DSR
Revolving DSR
0.08
Mortgage DSR
0.06
Total DSR
0.04
0.02
Year
20
02
q3
19
98
q4
19
95
q1
19
91
q2
19
87
q3
19
83
q4
0
19
80
q1
Proportion of Income
0.14
Alan Greenspan
“Some of the rise in the ratios of household debt to income may
not be evidence of stress. The dramatic increase during the
past decade in home purchases by previous renters has
expanded both the assets (that is, owned homes) and the
liabilities (mortgages) of the total household sector without
significantly affecting either overall household income or net
worth.
“Federal Reserve staff members estimate that approximately
one-tenth of current home mortgage debt outstanding, or
almost 1 percentage point of the average annual growth of
home mortgage debt, is attributable to renters who have
become homeowners since the early 1990s.
“One can scarcely argue that those previous renters are less well
off since becoming homeowners; yet, all else being equal, the
overall household debt as a percentage of income is 8
percentage points higher currently than it presumably would
have been had the homeownership ratio been stable since
1992.”
Risks of Subprime
Percentage
Foreclosure and Delinquency
16
14
12
10
8
6
4
2
0
Delinquency Rate
Foreclosure inventory rate
new foreclosure rate
Prime loans
Subprime
loans
FHA loans
Type of Mortgage
VA loans
Delinquency
Delinquency Rate ARM v. Fixed
18
16
14
12
10
ARM Delinquency Rate
8
Fixed Delinquency Rate
6
4
2
0
Prime
Subprime
ARM v. Fixed
4Q 2006 v. 1Q 2007
1.4
1.2
1
0.8
Quarterly Change ARM
Delinquency
0.6
Quarterly Change Fixed
Delinquency
0.4
0.2
0
Prime
-0.2
Subprime
Foreclosure: Caveats
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Foreclosure still primarily driven by local economic
conditions:
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Dramatic growth in Subprime loans for Nonowneroccupied homes: second homes and investment
speculation (HMDA Data)
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Foreclosures highest in Michigan, Ohio, and Indiana (Automobile
Industry)
Mississippi and New Orleans (Hurricanes)
1990-2005: 6.6%-17.3%
2001-2005: 8.6%-17.3%
Economics of Foreclosure and Delinquency:
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Option: Default if Property Values Fall
Duress: Default if Can’t Pay
Option and Duress are Related
Deliquency Caveats
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Prime Market Delinquencies
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Subprime Market
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30 days: 1.73%
60 days: 0.31%
90 days: 0.28%
30 days: 7.35%
60 days 2.02%
90 days: 4.04%
Can only be true if borrowers fall behind, miss three
payments and then beginning to pay again without
making up all the missed payments immediately.
Suggests subprime borrowers are essentially using
missed payments as a source of short-term, fixed-rate
line of credit.
Macroeconomic Risks
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Diversification: House Markets and
unemployment (human capital) correlated
May stifle labor market flexibility/mobility
Ripple Effects on Related Markets:
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Construction and employment
Home Depot
May be more unsteady than Prime:
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Risk-preferring consumers
Consumer Default Option
Regulatory Responses
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Need to Specify Regulatory Goals and
Tradeoffs
Substantive Regulation
Disclosure Regulation
Common Law
Competition
Substantive Regulation
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Intended Effects
Unintended Effects
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Term Substitution/Repricing: Heterogeneity of
Subprime Loans
Product Substitution
Rationing
Regulation and Rationing
“Predatory Lending Laws Can Cause Headaches,”
Parma Sun Post (July 10, 2003):
When David Sanderson recently applied to a lender for a second mortgage, he was
denied for an unusual reason. Undeterred, he went to another lender and was
denied again. Same thing happened at a third institution. In all three cases, he was
given the same reason for the denial—the lenders thought he lived in Cleveland and
claimed that the city’s anti-predatory lending law prevented them from giving him the
loan he needed. ***
Since Cleveland’s anti-predatory lending law caps interest charges, some lenders don’t
give second mortgages or home-equity loans to Cleveland residents having potential
credit risks.
But Sanderson lives in Fairview Park, a small, inner-ring suburb west of Cleveland.
“When we were applying for loans, the companies would key in our zip code, and
Cleveland would come up, he said.***
Desperate for a solution, Sanderson contacted his suburb’s City Hall. Fairview Park Mayor
Eileen Patton wrote a letter on his behalf, verifying he was a resident of the suburb.
“Her inquiry into the matter must have accomplished something, because we received a
call from one of the companies that initially turned us down, and offered to finance
us,” Sanderson said. “Sometimes it pays to e-mail the mayor.”
Patton said she and City Council have received similar requests from six other residents
who encountered the same problem as Sanderson’s.
Empirical Studies
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State and local anti-predatory lending laws lead
to reduction in volume of high-cost loans
More restrictive/severe laws lead to larger
reductions in loan originations for high-cost
loans (riskiest borrowers): Range from 26%
(NC) to 94% (NM)
Less impact on non-high-cost subprime (less risk
subprime borrowers)
Reduction in originations a result of reduction in
applications (rejection rate actually falls)
Good or Bad? Reduce “Predatory” or Subprime?
Doesn’t control for term substitution
Improving Disclosures
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FTC study:
http://ftc.gov/os/2007/06/P025505Mortga
geDisclosureexecutivesummary.pdf
26 In-Depth Interviews with their actual
documents (half prime, half subprime
customers)
819 tests with recent mortgage
customers: compared forms with current
disclosures (TILA, RESPA, GFE) and
prototype alternative disclosures
FTC Study Results
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Current mortgage cost disclosures fail to convey key
mortgage costs to many customers: loans more costly than
believed or contained restrictions of which they were unaware
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2/3 didn’t recognize prepayment penalty
¾ didn’t recognize optional credit insurance included
25% couldn’t identify total settlement charges
1/3 couldn’t tell when settlement charges included in loan
amount
1/3 didn’t recognize large balloon payment
90% couldn’t identify total up-front charges
More errors with more complex loans
Prototype disclosures significantly increased consumer
recognition of mortgage costs
No fundamental differences between prime and subprime
borrowers in ability to understand loan terms
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Prime 62.0% Correct v. Subprime 59.6%
Prototype Disclosures
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Based on Economic Theory and FTC Enforcement
Actions
Better disclosures substantially increased consumer
understanding
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Comprehension rose from 61% average for current disclosures
vs. 80% for prototype disclosures
80% of respondents viewing prototype could answer 70% of
questions correctly, versus 29% under current forms
Improvement largest for more complex loans
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Improvement of 22 percentage points complex loans and 16 simple
Improvement of 21.6 percentage points for prime borrowers and
22.4 percentage points for subprime borrowers for complex loans
66 percentage point increase in recognition of total up-front charges
43 percentage point increase in recognition of optional credit
insurance
24 percentage point increase in recognition of prepayment penalty
Lesson: Better Disclosures are Possible
Common Law
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Fraud
FTC
Federal Reserve
Education
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Government Programs: Assessment
Purpose of Education?
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Prevent Fraud
Make Market Work Better
North Carolina Experiment
Market and Contract
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How do we make market work better?
How do we make subprime loans more
homogeneous and more of a commodity?
Assignee Liability
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Freddie Mac and Fannie Mae will not purchase loans defined
as high cost in some states
Ratings services will not rate mortgage-backed securities
transactions that contain high cost loans in some states or
require additional credit enhancements for transactions that
include high-cost loans
Assignee liability would further raise risk of buying subprime
loans
Would likely reduce capital available for subprime market
Empirical evidence: Negative evaluation by a credit rating
agency associated with a large decline in originations of highcost loans and smaller increase in originations of non-highcost loans
Not clear that assignees can reasonably police this at low cost
Securitization may help to encourage subprime loans to be
more homogeneous in terms: Assignee liability would reduce
this
Suitability
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Would make lenders liable if they allow
borrowers to take home mortgages that
aren’t “suitable” or that “they can’t afford”
Based on securities law where seek to
protect people of limited means from
being sold securities that are too risky for
them
Net Benefit?
Jack Guttentag: “For there to be a net benefit, the
borrower must have the mortgage long enough for the
monthly cost reductions to exceed the upfront costs.
Only the borrower has any idea of how long they want
the mortgage…I recently reviewed a cash-out refinance
in which the borrower paid about $12,000 in refinance
costs and a quarter-percent rate increase in a loan of
$150,000 to raise $4,500 in cash. Was there a net
benefit? There is no objective way for the loan provider
to answer the question. The price was very high, but
maybe the borrower needed the cash to pay for lifesaving medicine for his children.”
Suitability
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Are the following motives suitable for ARM
or Interest Only Loan?
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Reduce cash outflow to invest the excess in
securities.
Reduce cash outflow to pay down a second
mortgage.
Pay principal when convenient.
Buy more house.
Reduce payment to avoid default.
Agencies Statement on Subprime
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OCC, Fed, FDIC, OTS, NCUA: June 29, 2007
Guidance, Not Proscriptive
Primary concern is “payment shock” not substantive
terms: prepayment penalties, balloon payments, interest
rate resets, lack of escrow for taxes and insurance
Evaluate borrower’s ability to repay at fully indexed rate
not just intro rate
Improve Disclosures
Limit use of reduced-documentation loans
Encourage workouts
Risk-layering
Prepayment penalties should end at least 60 days prior
to reset date
Awareness that may limit lending versus payment shock