The New Mortgage Market
Right after World War II, the American economy saw a major increase in homeownership. The overall homeownership rate rose from 45 to 65 percent in little more than a decade. This first ownership boom was characterized by the opening up of mortgage credit and ownership possibilities to the middle class. Millions of these middle-class households took advantage of newly available long-term, fixed-rate mortgages to buy houses, generally in the suburbs. These families moved out of the cities, purchased split-level houses, set up their backyard swing-sets, and placed their children in suburban public schools.
Low- and moderate-income families generally were unable to participate in this first postwar ownership boom. Many of them could not get mortgage credit at all; those that could, could not afford either the standard 20-percent down payment or the monthly payments. Minority families often could not participate because they faced discrimination on top of these other factors. By and large these families remained in rental housing. After its burst in the 1950s, America’s overall homeownership rate stayed close to 65 percent for another 35 years.
But lately there has been another, albeit smaller, ownership boom. As recently as 1994, America’s overall ownership rate was stable at 64 percent. But by 2005, it had risen to 69 percent (figure 1.1). Comparing earlier and later population sizes and ownership rates, nearly 12 million American households became new homeowners over this 11-year period. Like their middle-class cohorts in earlier years, these new homeowners now have a chance to build wealth, invest in their neighborhoods, send their children to better schools, and reap the other advantages of ownership. The latest increase moves the United States into the top rung in world homeownership rates. It has been the subject of intense cheering from presidents Clinton and Bush, though the federal deficit problem has been sufficiently constraining that most of this cheering has come from the bully pulpit, not in the form of new federal money.
The earlier homeownership boom focused on the middle classes and the prime mortgage market. These prime borrowers took out long-term mortgages, secured by their home, generally for 30 years. They paid mortgage rates of around 6 percent, and their mortgage covered 80 or 90 percent of their home price. The new ownership boom has moved one step down the income scale, focusing largely (though not exclusively) on the so-called subprime market. Subprime borrowers generally have lower incomes and often are not able to put as much down—their loan-to-value ratios often go up to 100 percent. Because of their worse credit history, subprime borrowers have to pay much higher interest rates, points, and fees, and they normally must accept prepayment penalties to get their home-secured loans. When the points and fees are amortized, the effective mortgage rate, called the average percentage rate (APR), is often in the double digits.
With rates this high, and with continuing pressures to expand ownership, people have been tempted to stretch the limits. Borrowers have sought ways to get in a house by keeping their down payments and monthly payments as low as possible. Lenders have sought new business. The combination has led to shortcuts that can often cause problems—excessive reliance on adjustable rate mortgages (ARMs), not verifying the repayment ability of the borrower, or not escrowing taxes and insurance payments. The mortgage of choice in this new subprime market is known as the 2/28—the interest rate is fixed rate for 2 years, and then for the rest of the 28 years the loan becomes an ARM. Sometimes this mortgage is varied to a 3/27, which works essentially the same way. Other types of “nontraditional” mortgage products, such as interest-only mortgages and negative-amortization mortgages, have also come into increasing use.1
While all income groups have participated in this new opening up of the mortgage market and rise in homeownership, low- and moderate-income households and racial and ethnic minorities have been at the center of the boom. From 1994 to 2005, the overall ownership rate rose from 64 to 69 percent. The rate for blacks rose from 42 to 49 percent, a rise that contributed to the increase of nearly 1.5 million black homeowners over the period. The rate for Hispanics went from 42 to 50 percent, accounting for many of the 2 million additional Hispanic homeowners (figure 1.2). The rate for households indicating more than one race rose from 52 to 60 percent, helping to add another 2 million homeowners. The rate for homeowners in the lowest tenth of the income distribution rose from 39 to 43 percent, in the second tenth from 45 to 49 percent, and so forth. An unusual number of all these groups is first-time homebuyers.
The subprime mortgage market developed for several reasons, essentially the material of chapter 2. One important factor was the Depository Institutions Deregulatory and Monetary Control Act of 1980. This act effectively abolished usury laws on first-lien mortgages. Usury laws, which prevent mortgages above a certain rate from even being made, acted to shut low- and moderate-income borrowers out of credit markets. As these usury laws passed from the scene, instead of denying mortgage credit, mortgage lenders could now make loans, though with higher interest rates to conform to the worse credit prospects of the new borrowers. It took a while for this change to take effect, but lately there has been a noticeable drop in mortgage denial rates (figure 1.3).
There were other factors. The 1990s saw the development and refinement of automated techniques for approving credit applications. Lenders now use credit scoring and similar techniques much more often than earlier, in the mortgage market and in other credit markets, leading to a faster and more inclusive mechanism for generating mortgage approvals. Some lenders now make mortgage approvals in a few minutes. Many old-line lenders such as banks and thrifts have set up subprime mortgage affiliates to make loans in the new part of the mortgage market. The 1990s saw the advent of mortgage brokers, intermediaries between lenders and borrowers, who are open, in the neighborhood, and available to place mortgages for a fee.
The influence of capital markets has played a significant role in the development of the subprime mortgage market. Fannie Mae and Freddie Mac, huge secondary market mortgage entities, began securitizing prime mortgages in the 1970s. By the 1990s, private Wall Street markets were doing it in the subprime market, introducing huge new sources of capital and financing largely unsupervised subprime mortgage lenders. Many of the latest problems have occurred because of the lack of careful lender supervision in this sector of the market.
On the nonprofit side of the ledger, there was also a substantial increase in community-based organizations (CBOs). These CBOs receive funds to subsidize affordable mortgages and make them to low- and moderate-income groups. Groups including NeighborWorks America (NWA) and the Opportunity Finance Network (OFN) have organized many local CBOs into vigorous and effective national networks.
Government regulations have had an impact as well. One that is particularly important is the Community Reinvestment Act (CRA), which gives banks and thrifts a responsibility to plow back funds to low- and moderate-income borrowers in their business areas, called assessment areas. CRA was first passed back in 1977, over the strong objections of the banks. But now, banks have made many low- and moderate-income mortgages to fulfill their CRA obligations, they have found default rates pleasantly low, and they generally charge low mortgages rates. Thirty years later, CRA lending has become a very good business (Gramlich 1999). 2
Yet another factor has been the economy itself. Recessions have been less severe and frequent in recent decades; in fact, there were only two between 1982 and 2006, and they were relatively mild. Meanwhile, the continual dampening of inflation in the 1980s and early 1990s eventually translated to lower nominal interest rates (both long-term and short-term). The combination of more stable employment and lower payments to support a mortgage created ideal economic conditions for expansion of the mortgage market.
One factor that does not seem to have influenced the growth in the subprime market much is a factor common for housing and mortgages in general, the well-known income tax preferences for housing—both the deductions for mortgage interest and property taxes and the generous treatment of capital gains on houses. The deductions for interest and taxes are unlikely to matter much because most low- and moderate-income homeowners do not itemize deductions. The generous capital gains treatment may not matter much either for households that are not paying a large amount in income taxes.
Reflecting all these positive factors, back in 1994 subprime mortgage originations were $35 billion, less than 5 percent of total mortgage originations. By 2005 subprime mortgage originations had risen to $625 billion, 20 percent of total originations (figure 1.4). This works out to a whopping 26 percent annual rate of increase over the whole decade. From being essentially nonexistent back in 1994, subprime mortgages are now 7 percent of the total mortgage stock. The subprime market was barely known in 1994, but merely a decade later, it is a huge factor. And the prime mortgage market expanded as well, again to accommodate the new loan demand emanating from all households, again including those low- and moderate-income households and racial minorities who could qualify for prime loans.
While it seems highly desirable to open up mortgage markets to these new borrowers, often for the first time, any major social movement on this scale will likely have drawbacks. And there are drawbacks associated with the subprime mortgage market. A first is simply its novelty. The subprime market opened for the first time, and as described above, an unusual share of the new mortgages were nontraditional products that featured adjustable rates. Short-term interest rates were very low in this period, for good macroeconomic reasons, and the initial cost of these new subprime mortgages was low. In addition, many lenders treated the two-year rate as a teaser, and advertised on this basis. Now that short-term rates have returned to more realistic (higher) levels, many subprime borrowers are suffering large payment shocks.
Further, house price have been rising smartly in many local markets, permitting many borrowers who may have gotten in trouble on their mortgage to sell the house, pay the prepayment penalty, and walk away from the whole deal without much loss. But this period is ending too. House price increases began to slack off in 2006. Because of the rise in short-term rates, combined with reduced house price appreciation, the new subprime mortgage market is now being stress-tested in a major way.
There are added complications. While the prime mortgage market is well regulated and supervised, with the major lenders—banks and thrifts—undergoing arduous examinations every three years, the subprime market is much less so. All mortgage markets operate under general federal statutes preventing discrimination, insuring proper disclosures, and regulating other aspects of mortgage transactions. But in the subprime market, 30 percent of the loans are made by subsidiaries of banks and thrifts, less tightly supervised than their parent company, and 50 percent are made by independent mortgage companies, state-chartered but not subject to much federal supervision at all. 3 Mortgage brokers are largely unsupervised, with minimal incentives to see that borrowers get their best deal and only indirect incentives to see that borrowers will be able to make their mortgage payments. And many subprime borrowers are from lower-income households, not well-versed in financial matters, and vulnerable to losses in income or payment ability.
The consequence of all these factors is that many borrowers could fall behind on their mortgage payments and go into delinquency status, sometimes even getting foreclosed on their loans. In a foreclosure, a borrower’s house is taken away and the borrower has to move out, typically losing any equity that has been accumulated in the house in the process. Foreclosures have never been much of a problem in the prime mortgage market, with overall foreclosure rates staying below 1 percent for many years. In the subprime market, by contrast, they have been about ten times as high, more like 7 percent (Joint Center for Housing Studies 2006, figure 25). And what happens now that short-term interest rates have risen and house price increases have slacked off is anyone’s guess. The Center for Responsible Lending (CRL), having studied 6 million recent subprime mortgages, predicts a sharp increase in foreclosure rates, up to 20 percent for newly made subprime loans (Schloemer et al. 2006).
There are problems on the other side of the market too. By February 2007, the Wall Street Journal reported that at least 20 subprime lenders had filed for bankruptcy, with more likely to follow.4 On April 2 they were joined by New Century Financial, the third-largest subprime lender in 2005 and a poster child for the go-go subprime market. A bond index fund that registers investors’ expectation that the value of low-rated subprime mortgage bonds will fail lost 30 percent of its value in the first two months of 2007.5
A mortgage foreclosure is the dramatic culmination of a process. But for every mortgage that is foreclosed, many others are very near foreclosure. A household may be struggling to make payments and in a situation where if the least little thing goes wrong, the household will fall behind. Things that could go wrong include loss of a job, a health problem (many of these families are among the 45 million Americans now without health insurance), or a problem with the house itself, such as a leaky roof.
There are indications that these pre-foreclosure issues may be serious as well. According to macroeconomic data, personal saving rates are negative and consumer debt burdens and personal bankruptcies are at all-time highs.6 Studies of longitudinal income data indicate that about 40 percent of first-time low-income homebuyers go back to renting after their first homeowning experience. It is not clear why, but this share is much higher than for other higher-income new homeowning groups, leading to the suspicion that many low-income homeowners are making distress sales (Herbert and Belsky 2006, chapter 3). Further studies from panel data indicate that the volatility of income flows for low- and moderate-income households has increased from earlier decades (Hacker 2006). And there are other ways in which households are now subject to increased risk. Putting this all together, the CRL estimates that another 5 to 10 percent of recent subprime mortgages are likely to be resolved by distress prepayments (Schloemer et al. 2006).
When something does go wrong, or even if it does not, the family may be at the mercy of predatory lenders, a group that often takes advantage of low-income, less-literate, less financially savvy, and more vulnerable borrowers. Such terms as asset-based lending (lending on the basis of the value of an asset in a foreclosure proceeding, not on the loan payment prospects), loan-flipping (rapid refinance of mortgages often without cause, but with big closing costs), equity-stripping (losing the equity in one’s house), and outright fraud and abuse have colored the foreclosure discussions (Renuart 2004; Goldstein 2007).
So there it is. There is both good news and bad news in the opening up of the mortgage market, particularly the subprime market. The good news is that millions of new homeowners, who formerly would have been denied mortgage credit can now take out mortgage loans, buy homes, live in better neighborhoods, and send their kids to better schools. A great many of these new homeowners, most likely a majority, are making their mortgage payments on schedule and building wealth in their homes.
The bad news is that a smaller share of these new homeowners is stretched thin, vulnerable to the least shock, saving very little, with high levels of consumer debt, at the mercy of predatory lenders, being forced to sell their houses early, and often ending up in foreclosure.
Chapter 4 examines actual data on new house purchases, new mortgages, foreclosures, and wealth creation to see how these gains and losses have been distributed, and are likely to be distributed in the future.
If the new homeowners had not become that, of course, they would have rented. Hence it is important to examine rental markets along with ownership markets, to make sure that these new homeowners are attracted into homeowning, not pushed in by the absence of available rental properties.
Unfortunately, conditions in the rental market are not very good either. Many renters have low and moderate incomes, and wages in these income levels declined in the 1980s, leading to the so-called hollowing out of the income distribution. Yet the nation has gone through an overall housing boom where prices have risen sharply, much more so than incomes for low- and moderate-income households.
The combination has put the squeeze on low- and moderate-income households, whether they own or rent. According to tabulations by the Joint Center for Housing Studies using data from the American Community Surveys, very large shares of low-income households—45 percent among owners and 57 percent among renters—are spending more than half their disposable income on housing, the normal definition of households with serious affordability issues. Another 21 percent faces moderate cost burdens, spending between 30 and 50 percent of their disposable income on housing.7 With spending at this level, households have very little left over for other needs. They are also likely to spend enormous amounts of time commuting to their jobs and away from their families.
On the supply side of the market, many properties have been removed from the available rental stock. There are numerous federal rent subsidy programs, but their effectiveness has been called into question, and expenditures have leveled off. A number of state and local policies also operate, perhaps unintentionally, to constrict the supply of affordable rental housing. The overall situation is not promising, especially if millions of foreclosed homes are taken out of supply (at least temporarily) and these homeowners are pushed back into an already-inadequate supply of rental housing.
Chapter 3, devoted to rental housing, will analyze the issues. It will review the overall rental situation, outline the criticisms of present programs, and suggest some new strategies. One obvious strategy involves plain-old expansion of supply. This may in turn involve more spending or a change in the mix of general income support and in-kind assistance. It will be extremely important to rethink the balance of responsibilities between the federal and state and local governments.
Chapter 3 also considers some promising new approaches for introducing ownership possibilities. The Department of Housing and Urban Development (HUD) has some experimental approaches for converting rent subsidies into down payment-escrow accounts. While at this point small numbers of potential homeowners have taken advantage of these possibilities, the particular experiences of these homeowners have been very favorable, with very low foreclosure rates (Lubell 2006). Unlike the open subprime mortgage market described earlier, most graduates of rent subsidy programs have undergone extensive homeowner counseling, and they may be more ready to take the step to ownership.
Of more quantitative importance is a new interest in manufactured housing, factory-built structures that can be located either on land owned by the homeowner or on land owned by an investor. In the former case, manufactured housing comes very close to normal single-family housing; in the latter case, it is a hybrid situation where the homeowner owns the structure and the landlord owns the land. Either way, manufactured housing is clearly cheaper than site-built housing. It is starting to make a real quantitative impact in many rural areas, particularly in the south. On the lending side, however, the results in the manufactured housing sector are essentially the same as in the rest of the subprime market, with low down payments and high foreclosures (Apgar et al. 2002).
The last issue to discuss is policy. It might be tempting to evaluate the subprime market, weighing the gains of homeowners who seem better off against the losses of those who seem worse off. But this type of assessment is not very meaningful. The opening up of mortgage markets happened, and at this point the changes are so fundamental that realistically they cannot be reversed. The nation cannot just close up the subprime mortgage market and go back to the ownership rates of a decade ago. Rather, the task is to manage the new situation and see if policy measures can retain the benefits of the new burst in ownership while lessening the costs.
Many types of policy changes might be considered. One set of potential changes affects the rental market. As argued above, significant expansions in supply could be considered, especially if house prices do not begin declining. Alterations in rent subsidy policies should be considered, in particular to give local authorities more power to tailor present subsidies to the needs of their own communities. There should also be new attention to rent-to-own possibilities and measures to improve the functioning of the manufactured housing market.
Another set of changes involves the mortgage market itself. Other product markets often have powerful incentives for suppliers to police themselves, and this self-policing could happen in the subprime market. Loans are often sold “with recourse,” meaning that if there are problems in the lending process, the lender is liable to take back the loan. Such provisions have not been much used until recently, but they do give lenders a powerful incentive to keep the process clean.
At a broader level, the Mortgage Bankers Association has developed a set of “best practices,” as have various state associations. These organizations could participate in grading institutions, loan products, or the like, or focus on making sure their members comply with the general guidelines.
Increased governmental regulation is another possibility. For high-cost mortgages, a federal statute—the Home Owner Equity Protection Act of 1994 (HOEPA)—provides some protections, preventing balloon payments (large scheduled increases in mortgage payments) in the first five years of a mortgage and prepayment penalties that last longer than five years. While the actual coverage of HOEPA loans is minimal, the statute’s provisions seem to lead lenders, and it could be used to guide the market.
HOEPA coverage could be extended to more subprime loans, and HOEPA could be used to prevent or limit various practices that have caused problems, as the Federal Reserve has already done. One set of measures that might be particularly important would extend the balloon payment provision to payment shocks more broadly, including the APR or monthly payments implicit in ARMs. With such changes, lenders might not be so ready to offer teasers or souped-up ARMs if they could not easily raise their mortgage payments back up. The HOEPA structure could also be used to make it much more costly for lenders to offer ARMs than fixed-rate mortgages.
Lenders and brokers in the subprime market should also face tighter supervision. Many lenders in the subprime market are either affiliates of banks and thrifts or their holding companies, not uniformly subject to direct supervision of their lending practices. Many independent mortgage companies are state-chartered and subject to even less scrutiny. Mortgage brokers are not really supervised at all. There were many abuses in this sector of the market, and there should be stronger efforts to police it. These measures are likely to require congressional legislation.
Large government-sponsored enterprises such as Fannie Mae and Freddie Mac play a huge role in mortgage markets generally, less so in the subprime market. But these enormous firms could step up their buying of subprime mortgages, or use their clout in other ways, to standardize and improve conditions in the subprime market, as they have done in the prime market. The Federal Housing Administration (FHA) and the Veterans Administration (VA) have been guaranteeing low-income mortgages for years. These mortgages are mainly long-term with fixed rates, not the instrument of choice in the new subprime market. FHA and VA might become more important, and stabilizing, factors once again by refinancing ARMS into long-term, fixed-rate mortgages.
The foreclosure process is governed by local laws, and local action is important too. By now there are many successful local anti-foreclosure programs, perhaps the most successful being the Home Ownership Protection Initiative (HOPI) in Chicago. The CBOs were helpful in getting HOPI going, they have gotten other initiatives going, and they are beginning to play a very active role in the fight against predatory lending and foreclosures more generally (Neighborhood Housing Services of Chicago 2006).
Indeed, in some respects the CBOs may be a secret weapon to improve the workings of the subprime market. Until now, CBOs have focused for the most part on expanding credit and homeownership. Now it may be time for CBOs to play defense and try to keep people in their homes. Anti-foreclosure efforts may be one aspect of this new fight, and promoting financial literacy may be another. Virtually every expert says that predatory lending and foreclosure problems would not be nearly as serious if borrowers were more literate financially.
Chapter 5, on potential policy changes, will examine all these issues.
1. Recently the Federal Reserve, along with the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Controller of the Currency, and the Office of Thrift Supervision, felt compelled to put out a guide to the new mortgage products, Interest-Only Mortgage Payments and Payment-Option ARMs: Are They for You? (Washington, DC, 2006). The Government Accountability Office (GAO) has a parallel piece, Alternative Mortgage Products: Impact on Defaults Remains Unclear, but Disclosure of Risks to Borrowers Could Be Improved, Report to the Senate Committee on Banking, Housing, and Urban Affairs (Washington, DC: GAO, 2006).
2. See also The Performance and Profitability of CRA-Related Lending, Report of the Federal Reserve to Congress, July 17, 2000.
3. These numbers come from tabulations of the Home Mortgage Disclosure Act (HMDA) data for 2005.
4. Nick Timiraos, “The Subprime Market’s Rough Road,” Wall Street Journal, 17 February 2007.
5. Serena Ng and James R. Hagerty, “Does the Subprime Index Amplify Risk?” Wall Street Journal, 27 February 2007. The fund is called the ABX-HE index.
6. The data are given in Fellowes (2006).
7. See Schloemer et al. (2006). The numbers are computed from the American Community Surveys and given in table A-6, page 36.