The Subprime Meltdown: A Primer*

Originally published 21 June 2007

Part 1 of the NERA Insights: Subprime Lending Series

Part I OF A NERA INSIGHTS SERIES

Forthcoming topics in this subprime lending series will include:

Finance & Accounting Aspects of a Securitization

Anatomy of a Fraudulent Conveyance

De-Mystifying the Economics of Complex Mortgage Transactions

The Domino Effect: Economic Impact of When Exotic Mortgages Reset

INTRODUCTION

The subprime mortgage market consists of loans to borrowers with high credit risk, and the mechanisms that have evolved to originate, service, and finance those loans. While this market has existed since the early 1980s, it was not until the mid-1990s that the growth of the subprime industry gained significant momentum. A decade ago, five percent of mortgage loan originations were subprime; by 2005 the figure had jumped to approximately 20 percent.1 Currently, there are about $1.3 trillion in subprime loans outstanding,2 with over $600 billion in new subprime loans originated in 2006 alone.3 Figure 1 shows the growth of subprime originations over time.

Several factors contributed to the fast growth of the subprime market. Most importantly, there has been an increase in the rate of securitization. That is, many more mortgages are now repackaged as mortgage-backed securities (MBS) and sold to investors. Also, there have been various credit innovations and a proliferating range of mortgage products available to the subprime borrower. These factors increased liquidity, reduced costs of lending, and enabled a greater number of previously unqualified borrowers to obtain loans. As of 2006, over 60 percent of all loans not eligible for prime rates were securitized.4

Several structural and economic factors have recently slowed subprime growth and increased delinquencies and foreclosures. Some of these factors include the rise in short-term interest rates and the decrease in the rate of home price appreciation (with actual price declines taking place in many locations). As a result of mounting defaults and delinquencies, one of the largest subprime lenders, New Century Financial Corporation, filed for bankruptcy on April 2, 2007. With the industry rapidly contracting, many other lenders have since followed suit, or simply exited the subprime market altogether. Consequently, many lenders, borrowers, and investors have filed lawsuits. While the subprime mortgage business is the focus of this primer, it is worth noting that this "meltdown" (as coined by the news media)5 is affecting all areas of subprime business, including automobile loans and credit card lending.

In this primer, we provide a brief description of the subprime mortgage industry and the process of securitization; we examine the economic factors leading to the deterioration of the US subprime mortgage industry; we identify some of the factors that differ between the current crisis and the 1998 crisis; and we discuss pending and potential litigation issues arising from the current industry difficulties.

THE SUBPRIME MARKET

Subprime Borrowers

A subprime borrower is one who has a high debt-to-income ratio, an impaired or minimal credit history, or other characteristics that are correlated with a high probability of default relative to borrowers with good credit history. Because these borrowers are inherently riskier, subprime mortgages are originated at a premium above the prime mortgage rate offered to individuals with good credit. Until recently, the spread between the average prime and subprime rate has remained at approximately 200 basis points.6

A method developed by the Fair Isaac Company assigns borrowers a credit score, or FICO score, that lies between 300 and 850. This is a measure of the borrower's likelihood of delinquency and default, where a lower score implies a greater risk to the lender. It is generally accepted that a FICO score less than 620 is considered subprime.87 In addition to having lower FICO scores, subprime borrowers typically have a loan-to-value ratio (LTV) in excess of 80 percent.8 A high LTV means that the borrower is making a smaller down payment. So, the lender assumes more risk with these individuals because it will be harder to recover the capital from the collateral if they default on their loans. This is especially the case when home price appreciation (HPA) is flat or negative.

Prepayment Penalties

A borrower may be required to pay a fee or penalty upon refinancing or paying off his mortgage ahead of schedule (called a prepayment). This mortgage feature, known as a prepayment penalty, is a prevalent feature of subprime loans.9 In the initial stages of a mortgage, the likelihood that a subprime borrower prepays in response to falling interest rates is higher than that for a prime borrower. Therefore, in order to mitigate prepayment risk, subprime lenders typically include prepayment penalties as part of the mortgage agreement. According to a 2006 study by the Federal Reserve Bank of St. Louis, the average duration of a prepayment penalty as of 2003 was between two and three years, depending on the type of mortgage product.10

Subprime Loan Purpose

A loan can be for a home purchase, for refinancing an existing mortgage (popularly called a "refi"), or for refinancing an existing mortgage and simultaneously borrowing cash against the equity in the home (called a "cash-out refi" or simply a "cash-out"). In the case of the subprime industry, refis have been very popular in recent years. Because cash-out refis allow the mortgagor to tap into built-up equity in the property, the borrower is able to benefit directly from appreciation of home prices. An academic study shows that 60 percent of subprime borrowers refinance into another subprime loan.11

Types of Subprime Mortgages

Broadly speaking, there are two main types of mortgages that apply across all credit sectors in the US. The traditional fixed-rate mortgage (FRM) is defined by constant periodic payments as determined by a "note rate" (the rate the borrower pays) that is fixed at loan inception.

By contrast, the adjustable-rate mortgage (ARM) is defined by variable periodic payments as determined by an index, such as the 12-month LIBOR, plus a fixed margin. The frequency at which the ARM note rate adjusts is usually either monthly, semiannually, or annually. Both these products typically have an amortization period of 30 years and a monthly payment frequency.

Many subprime loans are a hybrid of ARMs and FRMs in that they typically have a fixed note rate for the first two to three years and then revert to a classical ARM structure. For example, the 2/28 hybrid loana popular subprime producthas a fixed, low rate for the first two years (known as a teaser) and then becomes adjustable semiannually for the next 28 years as the note rate resets to the value of an index plus a margin. Other non-traditional products include negatively amortizing mortgages (NegAms) and interest-only mortgages (IOs). Negatively amortizing loans are FRMs or ARMs with payment schedules in which the borrower pays back less than the full amount of the interest to the lender, and the remainder is added to the principal. An IO mortgage can be either an ARM or an FRM such that the borrower pays only the interest for a set period of time. Once the IO period ends, the borrower has to pay down the principal in addition to the periodic interest. During the period 2004-2006, approximately 45 percent of subprime mortgages were ARMs or hybrids, 25 percent were FRMs, 10 percent allowed for negative amortization, and 20 percent were IOs.12

THE SECURITIZATION PROCESS

Introduction

A mortgage used to be a simple relationship between a homeowner and a bank or savings institution. The bank would decide whether to grant and finance the loan, collect payments, restructure the loan, or foreclose in case of defaults. Figure 2 illustrates borrowing under the traditional borrower-lender relationship.

Today, it is standard practice to pool mortgages with similar characteristics and package them into bonds that are subsequently sold to investorsa process known as securitization. This process involves many additional parties to the borrower and lender. In this section, we describe the process of securitization, introduce these additional parties, and discuss associated benefits and risks.

DESCRIPTION OF THE PROCESS AND KEY PLAYERS

What is Securitization?

Securitization is the creation and issuance of debt securities whose payments of principal and...