To loan or not to loan: a subprime dilemma.
Johnson, Gordon ; Roberts, William W. ; Trybus, Elizabeth 等
CASE DESCRIPTION
Students face a bank's decision to enter or not enter the
subprime home lending market. The situation is set just prior to the
problems that arose in 2007-2008. The case provides aggregate economic
data available at the end of 2006 and asks students to utilize this data
in recommending whether or not to enter this market. The case has a
difficulty level of three and is designed for a junior level course.
Including student presentations, the case is covered in three class
hours. It is expected that students will spend 3-5 hours outside of
class preparing this case.
CASE SYNOPSIS
A Senior Vice President for a midsized commercial bank is
contemplating getting her bank to move forward in extending subprime
loans. She has observed her competitors' profits rise following
their entry into this market. The two percent lending premium on
subprime loans is an attractive addition to bank income. In addition she
wants to help those customers who do not qualify for traditional, prime
home loans obtain the American dream of home ownership. With financial
advice and counseling, the vice president believes that customers who
have low credit ratings due to a few late payment, difficulty in
documenting their income, or, perhaps, a prior bankruptcy deserve
another chance and given the opportunity to move into their own home.
In making recommendations to the bank, the analysis is divided into
three parts: a statistical examination of delinquency potential and
credit ratings, an examination of aggregate economic implications (with
statistical analysis) for the home loan market, and an evaluation of the
ethical aspects of lending to subprime customers.
TO LOAN OR NOT TO LOAN: A SUBPRIME DILEMMA
Middletown, December 2006
Owning a home is part of the American dream. Having a home creates
ties to the community, provides stability, and promotes civic pride.
This desire for home ownership is so much a part of the American culture
that governments promote this ownership by providing significant tax
incentives. Mary Taggert is Senior Vice President for Mortgage Lending
at a medium sized bank, Citywide State, operating in the Midwest. Mary
prides herself in her role of helping her customers realize this
American dream. She wants to help extend the opportunity of home
ownership to her customers who previously would not qualify for a home
loan from Citywide by convincing the bank management to enter into the
subprime home lending market.
Citywide has been a fairly conservative banking institution,
concentrating on commercial lending to local business and low risk home
loans. The home loans extended by Citywide are to prime borrowers. These
borrowers have reasonably well established credit and borrow in loans
conforming to Fannie Mae or Freddie Mac criteria. Such loans can be
packaged and sold through these government-sponsored agencies. The risk
to the bank is low, many of the loans are sold to other institutions and
pension funds while the bank earns fees for processing the payments.
Prime borrowers generally had credit scores of 640 or higher.
In managing the loan business for her bank, Mary sees her job as
dealing with two significant problems. Prior to extending a loan she
must deal with adverse selection. Once the loan is extended she needs to
provide sufficient incentives to reduce the moral hazard problem.
Adverse selection results from asymmetric information. The potential
borrower knows more about their likely behavior and financial condition
than the bank. If the bank establishes a lending criteria that is
significantly more lenient than its competitors, the borrowers selected
are more likely to be higher risk and less likely to maintain their
payments. Once the loan is extended the borrowers might expose the bank
to unanticipated risk by failing to maintain the property. Mary sees
this moral hazard problem being reduced by requiring a minimum down
payment of 10 percent of the property's value. Since the first
party to incur a loss, should the property value decline, is the
homeowner, they have an incentive to maintain the value. The adverse
selection problem is managed by screening the applicants. A potential
borrower's credit score has proven to be a useful screening device.
Mary has been frustrated by having a screening rule that only
permits loans to highly qualified borrowers. Since her bank only issues
prime mortgage loans, she must turn away business from borrowers with
640 or lower credit scores. She has watched her competitors enter the
less than prime (subprime) market with a high degree of success and seen
many of the subprime borrowers succeed in making their housing payments,
improve their credit scores, and achieve their dream of home ownership.
Mary believed that these potential borrowers should not be denied the
opportunity of home ownership just because of a few late payments,
difficulty in documenting their income and, perhaps, a prior bankruptcy.
If they were given the opportunity and provided financial counseling to
help them manage their incomes, they would become good customers for the
bank, provide an additional source of bank income, and become more
productive members of the community.
The subprime market developed in the late 1990s. These loans were
designed to provide potential homeowners with less than perfect credit
the opportunity to get back on their feet, improve their credit rating,
and ultimately refinance into a prime loan at lower rates. The initial
subprime loans required a 20 percent down payment, had a fixed interest
rate for the first two years that was generally 2 percent above the
prime, 30-year fixed rate, and moved into an adjustable rate mortgage
(ARM) after two years. Moving into the 2000s, housing prices were
rising, equity was being built up for the homeowners and the loans were
profitable. With the subprime loans improving bank profitability, banks
and mortgage lending institutions moved to make their loans more
attractive. The down payment requirements dropped to 10 percent.
Institutions, in some cases, would issue loans for 100 percent of the
property's value (no down payment). In order to provide additional
loans, second loans were sometimes issued to subprime borrowers to
permit them to take acquired home equity out of the house. While the
latest movement towards more lenient lending criteria has Mary a little
worried, she still sees the subprime market as a vehicle to help both
her bank, with higher profits, and her customers, by providing them with
the opportunity of home ownership.
The subprime loans Mary wishes to make would require at least a ten
percent down payment, have a fixed rate for two years, include a
prepayment penalty during the first two years, and become an adjustable
rate mortgage (ARM) after two years. To compensate for the added risk
associated with these loans, the fixed rate would be 2 percent higher
than the bank's traditional prime home mortgage loans. The ten
percent down would protect the bank in the case of foreclosure, and the
future adjustable rate would make the loan attractive on the developing
secondary market for subprime loans. The ARM is indexed relative to the
6-mo LIBOR (London Interbank Offer Rate). Mary is comfortable with these
features. She believes that her borrowers would make their mortgage
payment, reestablish a higher credit score and be able to refinance
after two years into a lower rate prime loan.
Mary has some concerns over entering this market and has hired your
consulting firm to help her resolve these concerns and recommend how she
should proceed in this market. (Note: This case takes place in December
2006. While you may have future events in this industry available, your
recommendations should be made on information available prior to January
2007.)
1. Mary is concerned over how she should use credit ratings in
making these loans. She has gathered sample data on credit rating and
loan delinquencies which are provided for your use. Loans delinquent
beyond 90 days are likely candidates for foreclosure. Mary believes that
the bank is willing to accept a minimum credit score that has an
expected foreclosure rate of ten percent.
a. What is the relationship between days delinquent for a given
credit score?
b. What credit score is expected to yield an average delinquency of
90 days?
c. If Mary used that credit score as a minimum for extending these
subprime loans, what proportion of loans to individuals with that score
would you expect to be 90 or more days delinquent?
d. Assuming that Mary gets the bank to enter the Subprime market,
what minimum credit score would you recommend accepting? Why?
2. Mary is wondering whether or not the success seen by her
competitors is the result of recent increases in housing prices. She has
heard rumors that the Federal Reserve is likely to tighten Monetary
Policy and wonders what the implications are for her success in this
market. Mary has provided you with data on historic home price changes
in her area along with data on price level (CPI) changes, and interest
rates. Using this data, how concerned should Mary be over possible
changes in Federal Reserve policy?
3. Mary believes that the ten percent required down payment will
protect the bank from a loss of principal. However, should the loan
default, the funds are likely to be tied up, without interest income for
six to nine months. The funds could have been used to fund a prime loan
at around six percent interest with a default rate of well under one
percent. Mary is wondering whether or not the two percent premium paid
on the performing loans will cover the expected loss from the
nonperforming loans. She expects a potential default rate around 3-5
percent. The average home loan is about $200,000.
4. Mary wants to sell some of these subprime loans on the
developing secondary market. However, she also wants the bank to retain
some in their asset portfolio to add income and make the stockholders
happy. She wants an evaluation of the associated risks and a
recommendation on whether or not to hold or sell.
5. Finally, Mary is concerned over the potential ethical dilemma
over lending substantial amounts of funds to customers who have
demonstrated an inability to manage their finances or to not lend to
them and deny an opportunity to move forward on home ownership. Is it
ethical or not to extend loans in the Subprime market.
In making your recommendations it is suggested that you look into
the relationships between changes in home price, interest rates and
inflation.
The available data is in the excel spreadsheet subprimedata.xls.
Note that the data is contained in two sheets. The data is available
online at:
INK"http://www.csun.edu/~hceco009/subprimedata.xls"
http://www.csun.edu/~hceco009/subprimedata.xls
ACKNOWLEDGMENT
The authors are Professors in the College of Business and
Economics, California State University, Northridge and would like to
thank Fred Arnold for helpful information on the subprime mortgage
market.
REFERENCES: DATA SOURCES.
Fannie Mae, eFannieMae.com, "ARM Index Values--Fannie Mae
LIBOR," http://www.efanniemae.com/sf/rematerials/libor, 1989-2007.
Standard & Poor's, McGraw-Hill, "Indices,
S&P/Case-Shiller Home Price Indices, December 2007,
http://www2.standardandpoors.com/portal/site/
sp/en/us/page.topic/indices_csmahp, 2008.
Federal Reserve Bank of St. Louis, Economic Data, Series: D8NPTL,
Nonperforming Loans, http://research.stlouisfed.org/fred2/series/D8NPTL,
2008.
U.S. Department of Labor: Bureau of Labor Statistics, Consumer
Price Index for All Urban Consumers: All Items,
http://research.stlouisfed.org/fred2/data/CPIAUCSL.txt, 2008.
Gordon Johnson, California State University, Northridge
William W. Roberts, California State University, Northridge
Elizabeth Trybus, California State University, Northridge
Subprime Data--This data is
on two sheets.
credit days del.
scores
400 91
425 90
520 70
540 88
510 85
555 65
535 75
565 55
575 50
640 36
621 43
650 40
647 29
630 35
624 37
648 44
620 45
679 40
682 38
665 36
680 35
695 25
705 22
712 15
730 18
720 13
795 1
760 8
745 15
800 1
Housing Data
Time Year Qtr NONPerf ** CPI ***
1 1989 4 1.59 100.00
2 1990 1 1.72 101.82
3 1990 2 1.70 102.85
4 1990 3 1.79 104.91
5 1990 4 1.81 106.25
6 1991 1 1.86 106.73
7 1991 2 1.83 107.68
8 1991 3 1.84 108.47
9 1991 4 1.68 109.42
10 1992 1 1.65 110.13
11 1992 2 1.52 110.93
12 1992 3 1.44 111.72
13 1992 4 1.31 112.67
14 1993 1 1.23 113.46
15 1993 2 1.07 114.25
16 1993 3 0.99 114.81
17 1993 4 0.85 115.84
18 1994 1 0.82 116.47
19 1994 2 0.78 117.10
20 1994 3 0.73 118.21
21 1994 4 0.66 118.84
22 1995 1 0.66 119.71
23 1995 2 0.70 120.67
24 1995 3 0.71 121.22
25 1995 4 0.79 121.85
26 1996 1 0.83 123.12
27 1996 2 0.81 124.07
28 1996 3 0.78 124.86
29 1996 4 1.05 125.97
30 1997 1 1.06 126.52
31 1997 2 1.01 126.84
32 1997 3 1.00 127.63
33 1997 4 0.97 128.11
34 1998 1 0.98 128.27
35 1998 2 0.93 128.90
36 1998 3 0.91 129.45
37 1998 4 0.90 130.17
38 1999 1 0.99 130.48
39 1999 2 0.93 131.43
40 1999 3 0.89 132.86
41 1999 4 0.87 133.65
42 2000 1 0.85 135.39
43 2000 2 0.86 136.34
44 2000 3 0.91 137.45
45 2000 4 0.96 138.24
46 2001 1 1.03 139.43
47 2001 2 1.13 140.70
48 2001 3 1.17 141.01
49 2001 4 1.13 140.46
50 2002 1 1.21 141.33
51 2002 2 1.22 142.20
52 2002 3 1.22 143.15
53 2002 4 1.20 143.94
54 2003 1 1.22 145.61
55 2003 2 1.21 144.97
56 2003 3 1.15 146.56
57 2003 4 1.10 146.87
58 2004 1 1.03 148.14
59 2004 2 0.89 149.56
60 2004 3 0.86 150.28
61 2004 4 0.80 151.78
62 2005 1 0.76 152.73
63 2005 2 0.80 153.29
64 2005 3 0.80 157.40
65 2005 4 0.85 156.93
66 2006 1 0.80 156.93
67 2006 2 0.78 158.04
68 2006 3 0.77 159.86
69 2006 4 0.78 160.65
Home
Price
6 mo Change
Time inflation LIBOR * ****
1 4.779 8.355 1.91
2 7.219 8.521 2.45
3 4.023 8.646 1.32
4 7.927 8.219 0.41
5 5.099 8.000 0.23
6 1.784 6.849 0.33
7 3.545 6.355 0.32
8 2.930 5.959 2.88
9 3.488 4.852 2.01
10 2.596 4.391 3.69
11 2.865 4.214 3.55
12 2.845 3.525 2.17
13 3.387 3.724 3.24
14 2.801 3.254 2.67
15 2.782 3.438 3.02
16 1.936 3.459 4.51
17 3.570 3.505 4.53
18 2.181 3.880 6.65
19 2.169 4.958 5.02
20 3.769 5.448 3.35
21 2.138 6.479 2.39
22 2.921 6.521 2.02
23 3.162 6.047 3.54
24 1.833 5.923 4.61
25 2.085 5.751 4.40
26 4.137 5.390 2.53
27 3.075 5.636 2.25
28 2.545 5.805 2.98
29 3.535 5.581 4.53
30 1.756 5.883 3.73
31 1.000 6.008 4.27
32 2.489 5.847 4.18
33 1.486 5.951 3.82
34 0.494 5.837 4.46
35 1.970 5.787 5.56
36 1.716 5.628 6.02
37 2.196 5.194 7.63
38 0.972 5.096 8.53
39 2.902 5.300 9.36
40 4.314 5.856 11.19
41 2.377 6.114 11.31
42 5.180 6.365 10.65
43 2.797 6.897 11.93
44 3.239 6.760 11.24
45 2.298 6.536 11.52
46 3.422 5.009 13.53
47 3.618 4.016 12.51
48 0.899 3.235 12.78
49 -1.575 2.086 12.01
50 2.473 2.130 9.57
51 2.457 2.046 9.19
52 2.664 1.810 8.40
53 2.206 1.491 9.04
54 4.594 1.317 9.21
55 -1.744 1.212 8.33
56 4.346 1.180 8.71
57 0.863 1.223 7.57
58 3.435 1.180 8.16
59 3.830 1.630 9.08
60 1.901 2.049 7.80
61 3.984 2.567 7.14
62 2.496 3.165 6.63
63 1.449 3.546 5.65
64 10.602 4.074 5.53
65 -1.209 4.572 5.95
66 0.000 4.974 4.61
67 2.815 5.416 3.49
68 4.583 5.456 1.59
69 1.976 5.370 -0.89
0 FannieMae.Com index averaged over each quarter.
** FRB 8th District data set
*** Department of Labor, BLS, CPI
**** Standard and Poor's MPLS housing index, percent
change over a year prior.
Legend
NONPerf Nonperforming loans. Past due 90+ days. Ratio
CPI Consumer Price Index
inflation Annual percentage change in CPI
6 mo LIBOR 6 month LIBOR interest rate
