With so many people now saddled with poor credit, reestablishing "nonprime" lending is increasingly important to the future of homeownership, researchers at Harvard University’s Joint Center for Housing Studies argue in a new report.
The 212-page report, "Understanding the Boom and Bust in Nonprime Mortgage Lending," analyzes how the practice of pooling nonprime mortgages into securities that were sold to investors helped fuel the housing bubble and resulting financial crash and recession.
Although much of that territory has been explored before, the report also looks ahead, drawing lessons from the past to put forward ideas for "sustainable" nonprime lending, and advocating a continuing role for government in guaranteeing mortgage debt.
Nonprime lending — subprime, alt-A and higher-priced lending — grew at a rapid pace during the housing boom, collapsing when the secondary market for those loans froze in August 2007.
The secondary market for mortgage loans provides a channel for investors from around the world to fund home loans by purchasing mortgage-backed securities (MBS) and derivatives of those securities. The secondary market for mortgage loans took off in the late 1970s and early 1980s, spurred by the guarantees offered by Fannie Mae and Freddie Mac on MBS backed by mortgages that met their standards.
During the housing boom, nonprime mortgages were mostly funded by private-label mortgage-backed securities, which lacked those guarantees. Investment firms issued credit default swaps that were supposed to help manage the risk, and money from around the world poured into "private label" MBS.
(The situation is complicated by the fact that between 2004-07, Fannie and Freddie purchased approximately 32 percent of all private-label subprime and 11 percent of private-label Alt-A issues, or 23 percent of both markets combined, the report said, citing their federal regulator and Inside Mortgage Finance).
The report concludes that a glut of global liquidity helped fuel the housing bubble, leading to low interest rates and expectations of rising home prices. Demand from secondary market investors for mortgages with higher yields led to relaxed underwriting standards and mortgages with "unprecedented risks."
Blame for the financial crisis lies with financial institutions that established the underwriting standards, agencies that rated securities backed by nonprime loans, firms that wrote credit default swaps against them, and the regulators that were entrusted with policing the system, the report concluded.
"It was they — not mortgage brokers, mortgage bankers, or borrowers — that determined the products that could be offered, the underwriting standards that would be tolerated, the requirements for capital reserves against losses, and the incentive structure for mortgage brokers … that rewarded volume more than long-term loan performance," the JCHS report concluded. "In hindsight, these were significant regulatory and market failures."
The collapse of the secondary market for "private-label" MBS means that about 90 percent of mortgage loans today are bundled into securities whose payments are backed by Fannie Mae, Freddie Mac and Ginnie Mae (Ginnie Mae guarantees payments on MBS backed by mortgages insured by the Federal Housing Administration and the Department of Veterans Affairs).
With Fannie Mae and Freddie Mac in government conservatorship (thanks in large part to billions in losses on their own investments in private-label MBS), that’s a situation few view as sustainable.
Not only is the government playing a greater role in mortgage lending than at any time in history, but millions remain shut out of the housing market.
A recent Zillow analysis found that nearly one in three Americans are unlikely to get a mortgage loan on any terms, because their credit score is below 620 — the range often defined as "subprime."
While some of those people may not have the financial resources needed to become homeowners, other who might be ready to take the leap have been shut out of the lending system in the wake of the financial system’s collapse.
The overhaul of the financial regulatory system recently enacted by Congress should help restore mortgage markets to health, the report said.
New rules for implementing the Truth in Lending Act (TILA), Home Mortgage Disclosure Act (HMDA), Real Estate Settlement Procedures Act (RESPA), and Home Owner Equity Protection Act (HOEPA) are also steps "that will move the nation decisively in this direction."
The JCHS study also contains a number of additional recommendations for creating safer nonprime and nontraditional mortgage markets.
"Prudent" nonprime lending with traditional products deserves a fair test, the report said. "The evolution of nonprime lending in the mid-2000s was unfortunate not only for the damage it did, but also because it provided an unfair test of lending to borrowers with past credit problems."
A Community Advantage Program developed by Self Help, the Ford Foundation, and Fannie Mae in 2000 offered 30-year fixed-rate mortgages to borrowers who did not meet Fannie Mae’s underwriting standards.
When the performance of those loans was compared to adjustable-rate mortgage (ARM) loans with prepayment penalties originated by mortgage brokers, they performed four to five times better, the report said.
With proper underwriting, even nontraditional mortgages like pay-option and hybrid ARM loans can have their place, the report argued.
A 5/25 hybrid loan, for example, offers borrowers who intend to move within five years a lower interest rate, at the risk that the rate will reset if the borrower remains in the home longer than expected.
"This ought to be viewed as a useful and workable loan option rather than one to be avoided," the report said.
What’s needed is a model that can serve as a foundation for sustainable nonprime lending, the report said.
At the turn of the century, Fannie Mae and Freddie Mac began an "orderly process of expanding the pool of eligible borrowers in the prime conforming market."
Credit scores and mortgage scoring models were first used in the prime market to test whether underwriting standards could be adjusted to allow more borrowers to qualify without adding significantly to the expected risk profile of a pool of loans.
Lenders found they could ease one underwriting standard if they tightened another, allowing a larger proportion of low-income and minority borrowers to qualify for Fannie or Freddie guaranteed loans, without adding much to expected risk, the study said.
Fannie Mae’s "Expanded Approval" program was a risk-based pricing system, limited to select lenders, with low origination volumes of mostly fixed-rate loans. Initially, a hard 620 credit score cutoff was used.
But subprime and alt-A lenders pooling loans into "private label" MBS relaxed underwriting dramatically, the study said, relying heavily on simulations that included overly optimistic home price appreciation assumptions, or drawing conclusions from past performance of similar products that were more strictly underwritten.
There’s nothing inherently wrong with loan programs that will have higher default rates than those targeted at prime borrowers, but estimates of expected defaults should be considered reliable and based on actual performance history before pilot programs are expanded, the report said. Armed with that knowledge, yields can be set high enough to provide reserves to cover expected losses.
Borrowers must also be made to understand the risk they were taking on, and be able to comparison-shop for the best deal, the report said.
New consumer protections and disclosures in effect through RESPA and TILA in 2010 "go a long way" in explaining payment reset risks, fees, and rates, the report said. But mortgage originators still have much more information on rates and terms than borrowers.
One way the government could address the problem is to require that lenders publicly post prices for comparable loan products to a public website, the report said, such as a grid showing interest rates that borrowers grouped by credit score would be charged for particular products.
While the government’s role in guaranteeing MBS needs to be reevaluated, several important lessons about the financial crisis should be kept in mind, the report said.
Without FHA, Fannie Mae and Freddie Mac, "the mortgage market would have utterly collapsed," with "terrifying" consequences.
In September 2008, the federal government’s ability to go "in over a weekend and seize control of (Fannie and Freddie) was vital to keeping the financial system from collapsing and credit flowing through a network of thousands of private firms that originate and service loans."
Because of the vital role that secondary markets play in keeping money flowing into mortgage lending, the report concludes that the federal government’s role probably can’t be limited to insuring individual loans, as it does through FHA and VA.
Without federal guarantees on MBS and other structured securities (whether implicit or explicit), pension funds and insurance companies may no longer view them safe investments, and their issuers will have to rely on other "tricks of structuring credit risk that backfired so badly" during the financial crisis, the report said.
If the government now leaves the MBS guarantee business entirely up to shareholder-owned companies, as many have proposed, those companies "will come under pressure to move toward that lowest common denominator to retain market share" — just as Fannie and Freddie did during the housing boom, the report suggests.
