The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.
WASHINGTON - Is the American housing dream going sour? The Dow Jones industrial average tumbled 243 points in early March when missed payments by holders of subprime mortgages hit a four-year high and foreclosures on all homes a four-decade peak.
The homeownership dream first solidified in the 1950s. Then, the mortgage of choice was the 30-year, fixed-rate mortgage with 20 percent down. Millions of middle-class households bought suburban houses, erected backyard swing sets, and sent their kids to new public schools. The overall homeownership rate shot up from 45 percent to 65 percent in just more than a decade.
But most lower-income families either could not make the down payment or the monthly payments. Racial and ethnic minorities faced discrimination to boot. Most of these households continued to rent, and the American homeownership rate stabilized near 65 percent for 35 years.
Following that postwar boom, other seismic shifts reverberated in mortgage markets—usury laws ended, credit scoring developed, and Fannie Mae and Freddie Mac made advances in packaging mortgages into securities. The Community Reinvestment Act obligated banks and thrifts to make low- and moderate-income mortgage loans. Many new independent mortgage companies sprang into action.
As these factors converged, the subprime mortgage market blossomed. Lending swelled from almost zip in the mid-1990s to more than $600 billion today, one-fifth of all new mortgages. About 12 million new homeowners emerged—including many moderate-income households and minorities previously excluded—raising the overall U.S. homeownership rate to about 69 percent, among the world's highest.
While an arbitrary threshold (defined by the rate of interest charged) delineates the lower edge of the prime mortgage market from the subprime market, the two are different animals.
Most prime mortgages go to credit-worthy households; most subprime mortgages go to those with less-stellar credit records and carry higher rates, points, and fees. Most prime mortgages feature down payments; many subprime mortgages don't.
Made by banks and thrifts, most prime mortgages are fixed-rate. Negotiated by independent mortgage brokers, many subprime mortgages are adjustable. Most prime mortgages carry no prepayment penalties; most subprime mortgages do.
The bottom line? The new subprime mortgage market is far riskier than the old prime market. The foreclosure rate in the prime market has typically been less than 1 percent, compared with about 7 percent in the subprime market.
Now, the interest rates of the recent raft of subprime mortgages are about to rise (since they track short-term interest rates). The Center for Responsible Lending predicts foreclosure rates of about 20 percent, excluding distress sales. Millions of new homeowners who stretched to make their payments when short-term interest rates were very low are beginning to lose their homes.
Should we close down the subprime market and return to the world of the early 1990s? No way. Regrettable foreclosures notwithstanding, three-quarters of new homeowners are making their payments, building wealth and participating in the American dream.
Should we increase protections and safeguards for the new homeowners? Absolutely.
The key is stopping the shortcuts taken in the recent go-go subprime market. Lenders should scrutinize borrowers' ability to repay the loan, using the maximum rate on adjustable-rate mortgages—not the initial low rate. Lenders should escrow property taxes and insurance payments. Independent subprime lenders should be as carefully supervised as banks and thrifts making prime loans are.
Congress can get going, too. The 1994 Homeowner Equity Protection Act imposed controls on predatory lending by preventing balloon payments on high-priced mortgages, outlawing long-term prepayment penalties, and forcing lenders to evaluate borrowers' creditworthiness.
HOPEA's rate thresholds could be tightened up, and strictures on balloon payments could be applied to rate hikes on adjustable-rate mortgages and other payment shocks. If both lenders and borrowers had to confront the long-term costs of a mortgage, fewer households would lose their homes.
The clock cannot be turned back on the subprime mortgage industry. But financial regulators and legislators could look forward by promoting less risky homeownership.
Edward Gramlich, a member of the Federal Reserve System's Board of Governors from 1997 to 2005, is the Urban Institute's Richard B. Fisher Senior Fellow and author of the forthcoming "Subprime Mortgages: America's Latest Boom and Bust."
The views expressed are those of the authors and should not be attributed to the Urban Institute, its sponsors, staff, or trustees.
The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.
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