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Vol. 2, No. 11
NOVEMBER 2007
EconomicLetter
Insights from the
F e d e r al R e s e r v e B a n k o f Dallas
The Rise and Fall of Subprime Mortgages
by Danielle DiMartino and John V. Duca
After booming the first half of this decade, U.S. housing activity has retrenched
Past behavior suggests
sharply. Single-family building permits have plunged 52 percent and existing-home sales
that housing markets’
have declined 30 percent since their September 2005 peaks (Chart 1).
adjustment to more
A rise in mortgage interest rates that began in the summer of 2005 contributed
realistic lending
to the housing market’s initial weakness. By late 2006, though, some signs pointed to
standards is likely
renewed stability. They proved short-lived as loan-quality problems sparked a tightening
to be prolonged.
of credit standards on mortgages, particularly for newer and riskier products. As lenders
cut back, housing activity began to falter again in spring 2007, accompanied by additional rises in delinquencies and foreclosures. Late-summer financial-market turmoil
prompted further toughening of mortgage credit standards.
The recent boom-to-bust housing cycle raises important questions. Why did
it occur, and what role did subprime lending play? How is the retrenchment in lending
activity affecting housing markets, and
will it end soon? Is the housing slowdown spilling over into the broader
economy?
Rise of Nontraditional Mortgages
Monitoring housing today entails
tracking an array of mortgage products. In the past few years, a fastgrowing market seized upon such
arrangements as “option ARMs,” “nodoc interest-onlys” and “zero-downs
with a piggyback.” For our purposes,
it’s sufficient to distinguish among
prime, jumbo, subprime and nearprime mortgages.
Prime mortgages are the traditional — and still most prevalent — type
of loan. These go to borrowers with
good credit, who make traditional
down payments and fully document
their income. Jumbo loans are generally of prime quality, but they exceed
the $417,000 ceiling for mortgages
that can be bought and guaranteed by
government-sponsored enterprises.
Subprime mortgages are extended
to applicants deemed the least creditworthy because of low credit scores
or uncertain income prospects, both of
which reflect the highest default risk
and warrant the highest interest rates.
Near-prime mortgages, which are
smaller than jumbos, are made to borrowers who qualify for credit a notch
above subprime but may not be able
to fully document their income or provide traditional down payments. Most
mortgages in the near-prime category
are securitized in so-called AlternativeA, or Alt-A, pools.
Some 80 percent of outstanding
U.S. mortgages are prime, while 14
percent are subprime and 6 percent
fall into the near-prime category.
These numbers, however, mask the
explosive growth of nonprime mortgages. Subprime and near-prime loans
shot up from 9 percent of newly originated securitized mortgages in 2001 to
40 percent in 2006.1
The nonprime boom introduced
practices that made it easier to obtain
loans. Some mortgages required
little or no proof of income; others
needed little or no down payment.
Homebuyers could take out a simultaneous second, or piggyback, mortgage
at the time of purchase, make interest-only payments for up to 15 years,
Chart 1
Housing Activity Drops Off
Millions of units
2
Millions of units
8
Mortgage
rates start rising
1.8
7
1.6
1.4
6
Subprime
woes hit
1.2
Total existing-home sales
Single-family
building permits
5
1
.8
’00
’01
’02
’03
’04
’05
’06
’07
SOURCES: National Association of Realtors; Census Bureau; authors’ calculations.
EconomicLetter
Feder al Reserve Bank of Dallas
4
skip payments by reducing equity or,
in some cases, obtain a mortgage that
exceeded the home’s value.
These new practices opened
the housing market to millions of
Americans, pushing the homeownership rate from 63.8 percent in 1994
to a record 69.2 percent in 2004.
Although low interest rates bolstered
homebuying early in the decade, the
expansion of nonprime mortgages
clearly played a role in the surge of
homeownership.
Two crucial developments
spurred nonprime mortgages’ rapid
growth. First, mortgage lenders adopted the credit-scoring techniques first
used in making subprime auto loans.
With these tools, lenders could better
sort applicants by creditworthiness and
offer them appropriately risk-based
loan rates.
By itself, credit scoring couldn’t
have fostered the rapid growth of
nonprime lending. Banks lack the
equity capital needed to hold large
volumes of these risky loans in their
portfolios. And lenders of all types
couldn’t originate and then sell these
loans to investors in the form of residential mortgage-backed securities,
or RMBS —at least not without added
protection against defaults.
The spread of new products offering default protection was the second
crucial development that fostered subprime lending growth. Traditionally,
banks made prime mortgages funded
with deposits from savers. By the
1980s and 1990s, the need for deposits
had eased as mortgage lenders created
a new way for funds to flow from savers and investors to prime borrowers
through government-sponsored enterprises (GSEs) (Chart 2, upper panel).
Fannie Mae and Freddie Mac are
the largest GSEs, with Ginnie Mae
being smaller. These enterprises guarantee the loans and pool large groups
of them into RMBS. They’re then sold
to investors, who receive a share of
the payments on the underlying mortgages. Because the GSEs are federally chartered, investors perceive an
Chart 2
Mortgage Financial Flows
1980s–90s
Banks
De
po
sit
s
e s
im e
Pr tgag
or
m
Savers
and
investors
Prime
mortgage
borrowers
P
mo rime
rtg
age
s
SE
yG S
Bu MB
R
Mortgage
originators
2000–06
Banks
po
sit
s
e s
im e
Pr tgag
or
m
De
Prime
mortgage
borrowers
SE
yG S
Bu MB
R
Savers
and
investors
P
mo rime
rtg
age
s
.
y cy
Bu gen
na BS
no RM
Mortgage
originators
e/
rim me
bp pri es
Su ar- gag
ne ort
m
implicit government guarantee of them.
Fannie Mae and Freddie Mac, however,
haven’t packaged many nonprime
mortgages into RMBS.
Lacking the same perceived status,
nonagency RMBS—those not issued by
Fannie Mae, Freddie Mac and Ginnie
Mae—faced the hurdle of paying
investors extremely large premiums to
compensate them for high default risk.
These high costs would have pushed
nonprime interest rates to levels outside the reach of targeted borrowers.
This is where financial innovations came into play. Some — like collateralized debt obligations (CDOs),
a common RMBS derivative — were
designed to protect investors in
nonagency securities against default
losses. Such CDOs divide the streams
of income that flow from the underlying mortgages into tranches that
absorb default losses according to a
preset priority.
The lowest-rated tranche absorbs
the first defaults on the pool of
underlying mortgages, with successively higher ranked and rated tranches
absorbing any additional defaults. If
defaults turn out to be low, there may
be no losses for higher-ranked tranches
to absorb. But if defaults are much
greater than expected, even higherrated tranches may face losses.
Having confidence in the ability
of quantitative models to accurately
measure nonprime default risk, a brisk
market emerged for securities backed
by nonprime loans. The combination of
new credit-scoring techniques and new
nonagency RMBS products enabled
nonprime-rated applicants to qualify
for mortgages, opening a new channel for funds to flow from savers to a
new class of borrowers in this decade
(Chart 2, lower panel).
Nonprime Boom Unravels
As problems began to emerge in
late 2006, investors realized they had
purchased nonprime RMBS with overly
optimistic expectations of loan quality.2
Much of their misjudgment plausibly
stemmed from the difficulty of forecast-
Feder al Reserve Bank of Dallas
EconomicLetter
Nonprime
mortgage
borrowers
ing default losses based on the short
history of nonprime loans.
Subprime loan problems had
surfaced just before and at the start
of the 2001 recession but then rapidly
retreated from 2002 to 2005 as the
economy recovered (Chart 3). This
pre-2006 pattern suggested that as
long as unemployment remained low,
so, too, would default and delinquency rates.
This interpretation ignored two
other factors that had helped alleviate
subprime loan problems earlier in the
decade. First, this was a period of rapidly escalating home prices. Subprime
borrowers who encountered financial
problems could either borrow against
their equity to make house payments
or sell their homes to settle their
debts. Second, interest rates declined
significantly in the early 2000s. This
helped lower the base rate to which
adjustable mortgage rates were
indexed, thereby limiting the increase
when initial, teaser rates ended.
Favorable home-price and interest
rate developments likely led models
that were overly focused on unem-
Failure to appreciate the
risks of nonprime loans
prompted lenders to overly
ease credit standards.
The result was a huge
jump in origination
shares for subprime and
near-prime mortgages.
Chart 3
Quality of Prime and Subprime Mortgages Deteriorates
Percent
3
Percent
16
Share of conventional subprime
mortgages past due
2.8
15
Share of conventional prime
mortgages past due
14
2.6
13
12
2.4
11
2.2
10
9
2
’98
’99
’00
’01
’02
’03
’04
’05
’06
’07
NOTES: Conventional mortgages are those not insured by the Federal Housing Administration or guaranteed by the
U.S. Department of Veterans Affairs. Data are seasonally adjusted. Shaded area indicates recession.
SOURCE: Mortgage Bankers Association.
EconomicLetter
Feder al Reserve Bank of Dallas
ployment as a driver of problem loans
to underestimate the risk of nonprime
mortgages. Indeed, swings in homeprice appreciation and interest rates
may also explain why prime and
subprime loan quality have trended
together in the 2000s. This can be
seen once we account for the fact
that past-due rates—the percentage
of mortgages delinquent or in some
stage of foreclosure—typically run five
times higher on subprime loans (Chart
3). When the favorable home-price
and interest rate factors reversed, the
past-due rate rose markedly, despite
continued low unemployment.
Failure to appreciate the risks
of nonprime loans prompted lenders
to overly ease credit standards.3 The
result was a huge jump in origination
shares for subprime and near-prime
mortgages.
Compared with conventional
prime loans in 2006, average down
payments were lower, at 6 percent for
subprime mortgages and 12 percent
for near-prime loans.4 The relatively
small down payments often entailed
borrowers’ taking out piggyback loans
to pay the portion of their home
prices above the 80 percent covered
by first-lien mortgages.
Another form of easing facilitated
the rapid rise of mortgages that didn’t
require borrowers to fully document
their incomes. In 2006, these low- or
no-doc loans comprised 81 percent of
near-prime, 55 percent of jumbo, 50
percent of subprime and 36 percent of
prime securitized mortgages.
The easier lending standards
coincided with a sizeable rise in
adjustable-rate mortgages (ARMs). Of
the mortgages originated in 2006 that
were later securitized, 92 percent of
subprime, 68 percent of near-prime,
43 percent of jumbo and 23 percent
of prime mortgages had adjustable
rates. Now, with rates on one-year
adjustable and 30-year fixed mortgages close, ARMs’ market share has
dwindled to 15 percent, less than
half its recent peak of 35 percent in
2004.
In early 2007, investors and lenders began to realize the ramifications
of credit-standard easing. Delinquency
rates for 6-month-old subprime and
near-prime loans underwritten in 2006
were far higher than those of the same
age originated in 2004.
Other signs of deterioration also
surfaced. The past-due rate for outstanding subprime mortgages rose
sharply and neared the peak reached
in 2002, with the deterioration much
worse for adjustable- than fixed-rate
mortgages. In first quarter 2007, the
rate at which residential mortgages
entered foreclosure rose to its fastest pace since tracking of these data
began in 1970.
Lenders reacted to these signs
by initially tightening credit standards
more on riskier mortgages. In the
Federal Reserve’s April 2007 survey
of senior loan officers, 15 percent of
banks indicated they had raised standards for mortgages to prime borrowers in the prior three months, but a
much higher 56 percent had done so
for subprime mortgages. Responses to
the July 2007 survey were similar.
However, in the October 2007
survey the share of banks tightening
standards on prime mortgages jumped
to 41 percent, while 56 percent did
so for subprime loans. Many nonbank
lenders have also imposed tougher
standards or simply exited the business altogether. This likely reflects
lenders’ response to the financial disruptions seen since last summer.
The stricter standards meant fewer
buyers could bid on homes, affecting
prices for prime and subprime borrowers alike. Foreclosures added to
downward pressures on home prices
by raising the supply of houses on
the market. And after peaking in
September 2005, single-family home
sales fell in September 2007 to their
lowest level since January 1998.
The number of unsold homes
on the market has risen, sharply
pushing up the inventory-to-sales
ratio for existing single-family
homes from their low in January
2005 to their highest level since the
start of this series in 1989 (Chart
4). Condominium supply, which is
reflected in the all-home numbers, has
experienced an even sharper increase
since early 2005.
Chart 4
Existing-Home Inventories Rise from Late-2004 Lows
Months supply of unsold homes
11
10
9
8
Single-family homes
7
6
5
4
3
All homes
’89
’90
’91
’92
’93
’94
’95
’96
’97
’98
’99
’00
’01
’02
’03
’04
’05
’06
’07
NOTE: The all-homes category covers single-family homes, condominiums and nonrental apartments. Shaded areas
indicate recession.
SOURCE: National Association of Realtors.
Feder al Reserve Bank of Dallas
In the absence of homeprice appreciation, many
households are finding it
difficult to refinance their
way out of adjustable-rate
mortgages.
These high inventories will likely
weigh on construction and home prices
for months to come. After peaking in
early 2005, the Standard & Poor’s/CaseShiller index of year-over-year homeprice appreciation in 10 large U.S. cities
was down 5 percent in August—its biggest drop since 1991. While a Freddie
Mac gauge of home prices posted a
small year-over-year gain in the second
quarter, the pace was dramatically off
its highest rate, reported in third quarter 2005 (Chart 5).
In the absence of home-price
appreciation, many households are
finding it difficult to refinance their
way out of adjustable-rate mortgages
obtained at the height of the housing boom. Larger mortgage payments
could exacerbate delinquencies and
foreclosures, especially with interest
rate resets expected to remain high for
the next year (Chart 6). This suggests
mortgage quality will likely continue
to fall off for some time.
Financial Turmoil
By August 2007, the housing
market’s weaknesses were apparent:
loan-quality problems, uncertainty
about inventories, interest rate resets
and spillovers from weaker home prices. These, coupled with ratings agencies’ downgrading of many subprime
RMBS, led to a dramatic thinning in
trading for subprime credit instruments, many of which carried synthet-
EconomicLetter
Chart 5
Home-Price Appreciation Plunges
into Negative Territory
Percent (year-over-year)
18
S&P/Case-Shiller
U.S. index
16
14
12
10
8
Freddie Mac
repeat-sales index
6
4
2
0
–2
–4
’87
’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98
’99 ’00 ’01 ’02 ’03 ’04
’05 ’06 ’07
NOTE: Shaded areas indicate recession.
SOURCES: Freddie Mac; Standard & Poor’s/Case-Shiller.
Chart 6
Scheduled Resets on Adjustable-Rate Mortgages
Remain High
Billions of dollars in loans
60
50
Subprime
Jumbo
Near prime
GSE
40
30
20
10
0
July
2007
Nov.
March
2008
July
Nov.
SOURCE: Bank of America estimates based on LoanPerformance data.
ic, rather than market, values based
on models because of the instruments’
illiquidity.
On Aug. 14, the paralysis in the
capital markets led three investment
funds to halt redemptions because
they couldn’t reasonably calculate the
prices at which their shares could be
valued. This event triggered widespread concern about the pricing of
many new instruments, calling into
question many financial firms’ market values and disrupting the normal
workings of the financial markets.
Investors sought liquidity, putting
upward pressure on overnight interest rates and sparking a sharp upward
repricing of risk premiums on assets,
particularly those linked to nonprime
mortgages. One outcome was an
interest rate spike for both mortgagebacked commercial paper and jumbo
mortgages, which heightened financial
market uncertainty. In this environment, nonagency RMBS were viewed
as posing more liquidity and default
risk than those packaged by Fannie
Mae and Freddie Mac.
Facing greater perceived default
risk, investors began demanding much
higher risk premiums on jumbo mortgage securities, pushing up the cost
of funding such loans via securitization and encouraging lenders to incur
the extra cost of holding more of
these loans in their portfolios. This
contributed to a 1 percentage point
jump in jumbo interest rates between
June and late August, an especially
important increase given that jumbos
accounted for about 12 percent of
mortgage originations last year.
Although spreads between jumbo
and conforming loan rates have fallen
off their late-summer highs, they’re
still elevated. The higher rates have
dampened the demand for more
expensive homes, just as tighter credit
standards reduced the number of buyers for lower-end homes.
Macroeconomic Effects
A housing slowdown mainly affects
gross domestic product by curtailing
EconomicLetter
Feder al Reserve Bank of Dallas
appreciation since a 1986 law granted
a federal income tax deduction for
home equity loans (Chart 7).
Compounding the uncertain outlook for consumption is the likely
reversal of the early 2000s’ mortgage credit liberalization.8 This will
put further downward pressure on
home prices and housing wealth and
may curtail home equity loans and
cash-out refinancings. Finally, the
homebuying enabled by the easing of
credit standards in recent years may
have been at the expense of later
sales, further dampening the market
going forward.
The timing of housing wealth’s
impact on consumption may have
also changed. For example, before
the advent of equity lines and cashout refinancings, housing wealth
increases may have affected U.S. consumption mainly by reducing homeowners’ need to save for retirement.
Since then, such financial innovations
have enabled households to spend
their equity gains before retirement.
It’s unclear how much this may be
reversed by the 2007 retrenchment in
mortgage availability.
Looking Ahead
The rise and fall of nonprime
mortgages has taken us into largely
uncharted territory. Past behavior,
however, suggests that housing markets’ adjustment to more realistic
lending standards is likely to be prolonged.9
One manifestation of the slow
downward adjustment of home prices
and construction activity is the mounting level of unsold homes. The muted
outlook for home-price appreciation,
coupled with the resetting of many
nonprime interest rates, suggests foreclosures will increase for some time.
The sharp reversal of trends in
home-price appreciation will also
dampen consumer spending growth, an
effect that may worsen if the pullback
in mortgage availability limits people’s
ability to borrow against their homes.
Although recent financial market
turmoil will likely add to the housing
slowdown, there are mitigating factors.
Chart 7
Mortgage Equity Withdrawals Increasingly Move
with Housing Inflation and Mortgage Refinancings
Percent (2-quarter moving average)
Percent (year-over-year)
20
12
10
Interest-rate-driven
surge in cash-out and
other mortgage refinancing
8
{
housing construction and home-related
spending. It also reins in spending
by consumers who have less housing
wealth against which to borrow.5
Residential construction likely
exerted its largest negative effect in
third quarter 2006, when it subtracted
1.3 percentage points from the annual
pace of real GDP growth. Last year,
many forecasts predicted home construction would stop restraining GDP
growth by the end of 2007 and the
industry would start recovering in
2008. These predictions were made
before the tightening of nonprime
credit standards began in late 2006.
The change in standards will likely
prolong the housing downturn and
delay the recovery, although it’s hard
to tell precisely for how long. Since
single-family permits have already
fallen 52 percent from their September
2005 peak, however, the worst of the
homebuilding drag may be behind us.
The same may not be true for
housing’s indirect effect on consumption. Since the late 1990s, many
homeowners have borrowed against
housing wealth, using home equity
lines of credit or cash-out refinancing
or not fully rolling over capital gains
on one house into a down payment or
improvements on the next one. These
mortgage equity withdrawals gave
people access to lower cost, collateralized loans, which bolstered spending
on consumer goods. By one measure,
these withdrawals were as large as
6 to 7 percent of labor and transfer
income in the early to mid-2000s.
The magnitude and timing of
these withdrawals may have changed
in hard-to-gauge ways. New research
suggests housing wealth’s impact on
consumer spending grew as recent
financial innovations expanded the
ability to tap housing equity.6 This
is consistent with prior research on
housing’s connection to U.S. consumer
spending.7 Aside from the interestrate-related refinancing surge of 2002
and 2003, mortgage equity-withdrawal
movements have become increasingly
sensitive to swings in home-price
16
12
6
4
8
Housing inflation
2
4
0
0
Mortgage equity withdrawal
labor + transfer income
–2
–4
’77
’79
’81
’83
’85
’87
’89
’91
’93
’95
’97
’99
’01
’03
’05
’07
NOTE: Shaded areas indicate recession.
SOURCES: Freddie Mac; Bureau of Economic Analysis; Federal Reserve, flow of funds data; authors’ calculations.
Feder al Reserve Bank of Dallas
EconomicLetter
–4
EconomicLetter
First, the effect of slower homeprice gains on consumer spending is
likely to be drawn out, giving monetary policy time to adjust if necessary.
Second, the Federal Reserve has
been successful in slowing core inflation
while maintaining economic growth.
This gives policymakers inflation-fighting credibility, which enables them to
coax down market interest rates should
the economy need stimulus.
Third, even if the tightening of
mortgage credit standards undesirably
slows aggregate demand, monetary
policy could still, if need be, help offset
the overall effect by stimulating the
economy via lower interest rates. This
would bolster net exports and business
investment and help cushion the impact
of higher risk premiums on the costs of
financing for firms and households.10
are originated with the intent to fully sell them to
DiMartino is an economics writer and Duca a
vice president and senior policy advisor in the
Research Department of the Federal Reserve Bank
of Dallas.
Prices, Consumption, and Monetary Policy: A
investors. Bernanke discusses this in his remarks
at the 2007 Jackson Hole symposium (note 2).
4
The figures are for securitized mortgages. See
“Mortgage Liquidity du Jour” (note 1).
5
“Making Sense of the U.S. Housing Slowdown,”
by John Duca, Federal Reserve Bank of Dallas
Economic Letter, November 2006.
6
See “How Large Is the Housing Wealth Effect?
A New Approach,” by Christopher D. Carroll,
Misuzu Otsuka and Jirka Slacalek, National
Bureau of Economic Research Working Paper
no. 12746, December 2006; and “Housing,
Credit and Consumer Expenditure,” by John
Muellbauer, paper presented at the Federal
Reserve Bank of Kansas City’s Economic
Symposium, Jackson Hole, Wyo., Aug. 31–Sept.
1, 2007. Also see “Booms and Busts in the
UK Housing Market,” by John Muellbauer and
Anthony Murphy, Economic Journal, vol. 107,
November 1997, pp. 1701 – 27; and “House
Financial Accelerator Approach,” by Kosuke Aoki,
James Proudman and Gertjan Vlieghe, Journal of
Financial Intermediation, vol. 13, October 2004,
pp. 414 – 35.
Notes
7
The authors thank Jessica Renier for research
Repayments, and Debt on One-to-Four-Family
assistance.
Residences,” by Alan Greenspan and James
1
See “The Subprime Slump and the Housing
“Estimates of Home Mortgage Originations,
Kennedy, Finance and Economics Discussion
Market,” by Andrew Tilton, US Economics
Series Working Paper no. 2005-41, Board of
Analyst, Goldman Sachs, Feb. 23, 2007, pp.
Governors of the Federal Reserve System,
4 – 6. Securitized mortgages account for roughly
September 2005; and “Mutual Funds and the
70 to 75 percent of outstanding, first-lien U.S.
Evolving Long-Run Effects of Stock Wealth on
residential mortgages, according to estimates in
U.S. Consumption,” by John V. Duca, Journal
“Mortgage Liquidity du Jour: Underestimated No
of Economics and Business, vol. 58, May/June
More,” Credit Suisse, March 13, 2007, p. 28.
2006, pp. 202 – 21.
2
See, for example, Federal Reserve Chairman
8
This is a possibility to which Muellbauer (2007,
Ben Bernanke’s remarks, “Housing, Housing
note 6) alludes.
Finance, and Monetary Policy,” at the Federal
9
Reserve Bank of Kansas City’s Economic
10
Symposium, Jackson Hole, Wyo., Aug. 31, 2007.
policy, see “Aggregate Disturbances, Monetary
3
Part of the reason lenders eased credit stan-
is published monthly
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expressed are those of the authors and should not be
attributed to the Federal Reserve Bank of Dallas or the
Federal Reserve System.
Articles may be reprinted on the condition that
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Economic Letter is available free of charge
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Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX
75265-5906; by fax at 214-922-5268; or by telephone
at 214-922-5254. This publication is available on the
Dallas Fed web site, www.dallasfed.org.
See Duca (note 5).
For a discussion of the channels of monetary
Policy, and the Macroeconomy: The FRB/US
dards was that they planned to sell, rather
Perspective,” by David Reifschneider, Robert
than hold, the mortgages. The earlier easing of
Tetlow and John Williams, Federal Reserve
standards may have partly owed to the potential
Bulletin, January 1999, pp. 1–19.
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moral hazard entailed when nonconforming loans
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