"Why do people turn subprime?
- Posted by:
- Economist.com | NEW YORK
- Housing markets
WHO is a subprime borrower? You hear a lot of speculation about this small, but significant population. Were they greedy, irresponsible people who wanted a bigger house than they could afford? Or were they naive, seduced by unscrupulous lenders and the American dream of home ownership?
This Boston Fed paper (via Rortybomb) offers a precise definition of subprime borrower, which traditionally referred to a person with a low credit score. But the increase in subprime lending in the mid-1990s expanded the definition to someone who elects not to give detailed financial information, offers a low down payment, or wants a bigger house than a prime lender would grant them. In exchange for being subprime they paid higher interest rates.
One surprising thing about subprime borrowers is that up until the mid 2000s most loans were used to refinance rather than purchase a new home. So many subprime borrowers initially qualified for a prime loan, but then refinanced using subprime. This signals deeper financial issues with many subprime borrowers. It would take a significant shock to lower your credit score and make you refinance your mortgage at a higher rate. It suggests many subprime borrowers were struggling to stay in a home they already bought through a prime lender.
Subprime borrowers are more likely to default, primarily because they tend to have much less equity in their homes—negative equity brought on by a large and persistent fall in home prices, rather than a spell of unemployment, is the biggest determinate of default. Even if you have negative equity in your home, if you expect prices to increase in the near future and turn your equity positive you will be less likely to default.
In a later paper the authors wonder if investors in mortgage-backed securities did not appreciate the consequences of lending to vulnerable borrowers with little equity in their homes. It now seems astounding that the primary concern for banks when pricing mortgage securities was pre-payment rather than default risk. Prepayment from refinancing using a prime mortgage is sensitive to interest rates, but people who refinance using a subprime mortgage do so because they've faced an income or wealth shock (why else would they refinance at a higher rate). The authors scoured analyst reports from the mid-2000s to retrace the thinking behind the mortgage market implosion:
Mortgage pricing revolved around the sensitivity of refinancing to interest rates; subprime loans appeared to be a useful class of assets whose cash flow was not particularly correlated with interest rate shocks. Thus, Bank A analysts wrote, in 2005:
[Subprime] prepayments are more stable than prepayments on prime mortgages adding appeal to [subprime] securities.
In some respects subprime was more desirable than prime mortgages.
The Fed study concludes that investors were aware that borrowers with little equity in their homes often default when house prices fall. The problem is they applied a trivial probability to house prices falling."Me: