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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO AUGUST 2007 NUMBER 241 Chicago Fed Letter Comparing the prime and subprime mortgage markets by Sumit Agarwal, financial economist, and Calvin T. Ho, associate economist Against the backdrop of news reports on high mortgage delinquency rates, this article examines recent trends in mortgage lending and compares the prime and subprime markets in particular. In this Chicago Fed Letter, we analyze the different mortgage types (prime versus subprime) and products (adjustable-rate versus fixed-rate) to explain differences in mortgage delinquency rates over time and across the Seventh Federal Reserve District.1 In light of recent news reports about the problems 1. Mortgage delinquency rates in the subprime lending market, our purpercent pose is to document 16 the recent trends in Conventional subprime mortgage lending mortgages and analyze the rising 12 level of delinquencies in the subprime mort8 gage market. We show that the subprime mortgage mar4 ket is facing substantial problems, as measured Conventional prime mortgages 0 by delinquency rates, 1998 ’99 2000 ’01 ’02 ’03 ’04 ’05 ’06 ’07 while the prime mortNote: The delinquencies are for mortgages that are 30, 60, and 90 days past due. gage market is expeSource: Mortgage Bankers Association. riencing more typical delinquency rates, i.e., at historical averages (see figure 1). Within the subprime mortgage market, we observe a substantial increase in delinquency rates, mostly for adjustable-rate mortgages (ARMs). Since the subprime ARM market is less than 7.5% of the overall mortgage market and a vast majority of subprime loans are performing All mortgages well, we believe that the subprime mortgage problems are not likely to spill over to the rest of the mortgage market or the broader economy. However, looking at the five states in the Seventh District, we find a substantial growth of adjustable-rate subprime lending in Indiana and Michigan— states that have experienced recent slowdowns in economic activity. We also find that Indiana and Michigan have higher delinquency rates than the national average. What are prime, subprime, and Alt-A mortgages? The main difference between prime and subprime mortgages lies in the risk profile of the borrower; subprime mortgages are offered to higher-risk borrowers. Specifically, lenders differentiate among mortgage applicants by using loan risk grades based on their past mortgage or rent payment behaviors, previous bankruptcy filings, debt-toincome (DTI) ratios, and the level of documentation provided by the applicants to verify income. Next, lenders determine the price of a mortgage in a given risk grade based on the borrower’s credit risk score, e.g., the Fair, Isaac, and Company (FICO) score, and the size of the down payment. Lenders generally charge the prevailing prime mortgage rates to borrowers with lower credit risks as reflected by their 2. Adjustable-rate mortgage (ARM) delinquency rates Mortgage market size and growth finance home improvements. The mortgage business landscape transformed as technology made it possible to automate credit checking and underwriting procedures, thereby significantly reducing the time and expense involved in these processes. Furthermore, the use of credit scoring systems made it possible to expedite the evaluation of mortgage applicants’ risk profiles and increase the volume of applications processed. The residential mortgage market in 2006 Conventional subprime ARMs was $10 trillion, representing one-quarter 12 of the total debt market in the U.S. Over the past few years, the 8 $1.5 trillion subprime mortgage market has experienced expo4 The expansion of the subprime mortnential growth. Acgage market has helped make homeConventional prime ARMs cording to Inside ownership possible for households that Mortgage Finance 0 may not have qualified in the past. While 1998 ’99 2000 ’01 ’02 ’03 ’04 ’05 ’06 ’07 Publications, subthe gains in homeownership are broad prime mortgages acNote: The delinquencies are for mortgages that are 30, 60, and 90 days past due. based, they are especially large for the Source: Mortgage Bankers Association. counted for over 20% minority and low-income communities.3 of all mortgage origiHowever, weaker financial conditions nations in 2006, up and lower credit scores of the subprime having met a minimum FICO score re- from 6% in 2002; the Alt-A mortgage borrowers have led to a higher cost of quirement and their having a sufficient market alone grew from $85 billion in borrowing; this, combined with declindown payment. Generally, subprime 2003 to $400 billion in 2006.2 ing or flat house prices and rising inborrowers pay 200 to 300 basis points terest rates, has put upward pressure Adjustable-rate mortgages have fixed above the prevailing prime rates. Othon the delinquency rates for subprime interest payments initially and adjust er costs associated with risk-based pricARM borrowers. after a specified interval to a new ining in the subprime mortgage market terest rate that is based on the prime include higher upfront origination Delinquencies in prime and rate at that time. Data show that ARMs fees (e.g., application fees) and presubprime mortgages have gained popularity over fixed-rate payment penalties. Data provided by the Mortgage Bankers mortgages across both prime and subAssociation indicate that the overall Finally, borrowers who have relatively prime markets. They usually carry mortgage delinquency rate has been good current credit scores, but who fail comparatively low initial rates, which hovering around 4% since the early to provide sufficient documentation to increase the appeal of this type of 1990s. Although the rate has edged up verify income or who have high DTI mortgage. The percentage of prime to about 4.9% in the past 12 months, ratios, are eligible for Alt-A loans. Of loans that are ARMs, for instance, the nonprime loans, Alt-A loans are jumped from 10.6% considered to be the least risky. Alt-A in December 2001 to 3. Prime mortgage delinquency rates, by region borrowers generally have credit scores 18.2% in December percent falling between those of prime and 2006, while the frac5 subprime borrowers. tion of subprime ARMs rose from According to the Mortgage Bankers 4 27.6% in December Association, prime mortgages make up 1998 to about 50% about 80% of the mortgage market, in December 2006. 3 subprime mortgages about 15%, and Alt-A loans about 5%. These figures Evolution of the 2 represent the stock of mortgages outsubprime mortgage standing as of 2006. banking industry percent 16 The interest rates for prime, subprime, and Alt-A mortgages can be fixed for the term of the loan or adjustable after a predetermined period (typically, one, three, or five years), depending on the financing needs and characteristics of the borrower. Subprime mortgages gained popularity in the early 1990s, when falling interest rates made them appealing to homeowners as a way to refinance existing mortgages, consolidate debt, or 1 0 1998 ’99 2000 ’01 ’02 United States Illinois ’03 Indiana Iowa ’04 ’05 ’06 ’07 Michigan Wisconsin Notes: The delinquencies are for mortgages that are 30, 60, and 90 days past due. All delinquency rates are nonseasonally adjusted. Source: Mortgage Bankers Association. The subprime mortgage market constitutes about 15% of percent 25 the overall mortgage market, and about 50% of subprime mort20 gages are ARMs. While there has been a 40% 15 increase in subprime ARM delinquencies 10 over the past two years, the rest of the 5 mortgage market, especially the fixed-rate subprime mortgage 0 1998 ’99 2000 ’01 ’02 ’03 ’04 ’05 ’06 ’07 market, has not expeMichigan United States Indiana rienced a similar hike Iowa Wisconsin Illinois in delinquency rates. Notes: The delinquencies are for mortgages that are 30, 60, and 90 days past due. This suggests that All delinquency rates are nonseasonally adjusted. about 7.5% of the Source: Mortgage Bankers Association. overall mortgage market has experienced a significant increase in delinquencies, it remains near historical lows (see figreducing the likelihood of any spillover ure 1). This is largely because prime effects on the rest of the mortgage marloans, which make up 80% of the mortket. However, the problem may be more gage market, have stable delinquency significant for some states, as we discuss rates. Both fixed-rate and adjustablerate prime mortgage delinquency rates in the next section. are approximately 2% and 4%, respecMortgage activity in the tively—just around their correspondSeventh District ing historical averages. The growth of the subprime mortgage Subprime mortgages, on the other hand, market has varied across the five states have exhibited significant increases in in the Seventh District. For example, delinquency rates. In December 2006, the share of subprime mortgages in over 13% of subprime loans were delin- Michigan grew from 2% in 1998 to just quent in the U.S., up from about 10% below 16% in 2006, while the share of during the housing boom a few years subprime mortgages in Iowa grew from earlier. More than 14% of subprime less than 1% in 1998 to 8% in 2006. In ARMs were delinquent in December contrast to Indiana and Michigan, the 2006, up from about 10% two years other three states of Illinois, Iowa, and earlier, and over the same period, Wisconsin had shares of subprime mortthere were twice as many foreclosures gages that were below the national on homes (i.e., loan defaults leading average of 15.2% at the end of 2006. to seizures of homes by lenders). Figures 3 and 4 show that Indiana and Figure 2 shows the delinquencies for the Michigan, which have experienced slowprime and subprime ARM markets. In downs in the manufacturing sector, have recent years, the delinquency rate for reported higher rates of delinquencies— prime ARMs was below its historical high sometimes twice as high as the nationof 4%, but the delinquency rate for al average in both prime and subprime subprime ARMs increased from 10% in mortgage markets. At the end of 2006, September 2004 to 14% in September the delinquency rates for prime mort2006. However, over the same period, the gages were 4.0% and 4.2% for Indiana delinquencies for the fixed-rate prime and Michigan, respectively, while the and subprime markets were below their national average was 2.8% (see figure 3). historical highs of 2.5% and 16.6%, respectively, and stayed relatively flat. 4. Subprime mortgage delinquency rates, by region At the end of 2006, the delinquency rate for subprime mortgages was 21.1% in Michigan and 14.2% across the nation. All five Seventh District states had higher delinquency rates than the national average, varying between 14.7% in Wisconsin and 21.1% in Michigan (see figure 4). In addition, Indiana has a higher share of subprime mortgages as a share of total mortgages, thus exacerbating the impact of the subprime problems. Specifically, Indiana’s share is 18.3%, or 3.1% above the national average. Can market participants help prevent the spread of subprime problems? There are a number of recent public and private initiatives that should help prevent the spread of the subprime problems to the broader economy. Freddie Mac, a U.S. government-sponsored enterprise that issues mortgage-backed securities, has indicated that it would purchase $20 billion of loans from subprime borrowers facing an ARM reset. Fannie Mae, a similar entity, has created a product allowing for 40-year home loans. Also, financial institutions, such as Citibank and Bank of America, have set up a $1 billion fund to help provide subsidized loans to homeowners who Michael H. Moskow, President; Charles L. Evans, Senior Vice President and Director of Research; Douglas Evanoff, Vice President, financial studies; Jonas Fisher, Economic Advisor and Team Leader, macroeconomic policy research; Richard Porter, Vice President, payment studies; Daniel Sullivan, Vice President, microeconomic policy research; William Testa, Vice President, regional programs and Economics Editor; Helen O’D. Koshy, Kathryn Moran, and Han Y. Choi, Editors; Rita Molloy and Julia Baker, Production Editors. Chicago Fed Letter is published monthly by the Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and are not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System. © 2007 Federal Reserve Bank of Chicago Chicago Fed Letter articles may be reproduced in whole or in part, provided the articles are not reproduced or distributed for commercial gain and provided the source is appropriately credited. Prior written permission must be obtained for any other reproduction, distribution, republication, or creation of derivative works of Chicago Fed Letter articles. To request permission, please contact Helen Koshy, senior editor, at 312-322-5830 or email Helen.Koshy@chi.frb.org. Chicago Fed Letter and other Bank publications are available on the Bank’s website at www.chicagofed.org. ISSN 0895-0164 are on the brink of foreclosure. Additionally, some states have raised funds to help homeowners refinance risky mortgages; for example, Ohio has raised $100 million for this purpose. Other states, such as Pennsylvania, New York, and New Jersey, are pursuing similar strategies. Finally, in response to the rising level of delinquencies, lending institutions have tightened credit and underwriting standards. Credit spreads on new subprime securitizations have increased, and subprime securities originations have slowed. These measures, together with better disclosure by lenders, efforts to prevent lending fraud and abuse, and financial counseling for potential and existing borrowers, could go a long way toward helping households keep their financial obligations more manageable and reducing delinquency rates. 1 The Seventh Federal Reserve District comprises all of Iowa and most of Illinois, Indiana, Michigan, and Wisconsin. 2 See Inside Mortgage Finance Publications, 2006, Mortgage Market Statistical Annual 2006, 2 vols., Bethesda, MD. 3 For further details, read the speech by Federal Reserve Chairman Ben Bernanke at www.federalreserve.gov/boarddocs/ speeches/2007/20070517/default.htm.
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