Subprime mortgage lending.

Adamson, Joseph ; Zywicki, Todd J.

Should "borrowers beware" of subprime mortgages, which lead to "an endangered dream" of homeownership, as headlines in the Washington Post and Wall Street Journal recently said? Or is "debt once again miscast as the villain," as a New York Times columnist wrote? Those are the basic questions that the federal financial regulatory agencies are asking in a proposed statement responding to the recent collapse of many subprime mortgage lenders.

One of the main questions that the agencies ask is whether subprime mortgages are "inappropriately risky." Evidence shows that for lenders and borrowers acting in good faith, they are unequivocally beneficial.

Subprime borrowers usually have riskier credit histories than prime borrowers. Lenders charge higher interest rates or include terms such as prepayment penalties to offset the higher risk. Despite the higher costs, subprime mortgage originations have increased more than five-fold over the past decade. Millions of borrowers previously unable to obtain mortgage financing can now purchase their own homes. As subprime mortgages have become more widespread, the national homeownership rate jumped from a plateau of around 65 percent to its current level, near 69 percent.

But when the housing market declined in early 2007 and foreclosures increased sharply, subprime lending drew the attention of consumer interest groups and regulators. Many people see higher interest rates and restrictive terms, and conclude that subprime lending is predatory. True, there are some fraudulent or deceptive lenders; but in most cases lenders charge higher rates and fees not in a cynical grab for higher profits, but because subprime borrowers are riskier than prime borrowers. Moreover, most lenders offer loans only to the best subprime borrowers, those who nearly qualify for prime mortgages.

Prime borrowers are very reliable customers for lenders. In the fourth quarter of 2006, foreclosures for that group were only 0.5 percent of loans. Subprime borrowers were riskier; in the same quarter, foreclosures accounted for 4.53 percent of loans. While subprime borrowers are nearly 10 times as likely as prime borrowers to meet foreclosure, more than 95 percent of borrowers do not reach foreclosure. If the subprime mortgage market had not expanded over the past decade, that 95 percent figure would represent millions of responsible would-be borrowers without an opportunity to own a home.

An alternative explanation to the subprime crisis is that subprime borrowers were most exposed to the housing bubble. The majority of subprime loans carry adjustable rates, and interest rates began to rise at the same time as housing prices fell, leaving borrowers facing higher mortgage payments as they were losing equity in their homes. This "perfect storm," as economist Todd Sinai of the University of Pennsylvania calls it, resulted in borrowers stretched to their financial max.

REGULATION The proposed statement issued by the five regulatory agencies reinforces previous guidelines on subprime lending and questions whether new controls over the industry are necessary. The current and proposed regulations include both substantive regulations and disclosure regulations. These are two of the most common regulatory regimes for credit markets, but each must be carefully designed in order to be effective.

Substantive regulations, in fact, are generally thought by economists to be ineffective. In the subprime market, one of the prime targets for regulation is the prepayment penalty. Lenders add this penalty to a mortgage because prepayment and refinancing are very common in the subprime market. After a few months of regular payments, subprime borrowers may be able to qualify for a prime loan or a subprime loan with better terms than their current loan. The prepayment penalty allows lenders to recoup the initial expenses of a mortgage. When lenders originate loans without these fees, they often simply charge a higher interest rate, raise down payment requirements, or require that fees be paid upfront and not financed with the rest of the loan. If lenders cannot substitute different methods of mitigating risk, they often stop offering those loan products.

Disclosure regulations can be more effective, but they must also be carefully designed. Many required disclosures are irrelevant to a large group of borrowers. And requiring every possible disclosure is counterproductive, resulting in information overload. A 2002 Federal Trade Commission study found that certain disclosures (in this case, of mortgage broker compensation) may confuse borrowers and lead them to make poor decisions. Some of the published comments for the proposed statement have already raised the issue of complicated disclosure rules.

The subprime crisis has followed the pattern of other credit innovations --credit cards, personal finance loans, and other recent options. Lenders and borrowers take advantage of the new product, and some fare poorly in the speculative bubble. But most borrowers are better off in the end. New rules for the subprime market will likely result in many responsible borrowers made unable to access mortgage financing.