From the Subprime to the Exotic: Excessive Mortgage Market Risk and Foreclosures

Abstract

Problem: The recent rapid growth of high-risk mortgage lending raised the financial risk profile facing not only the American homeowner but entire neighborhoods. From the perspective of planners, the problem of increased and geographically concentrated foreclosures is the most critical outcome that has resulted from high-risk mortgage markets.

Purpose: This article analyzes recent trends in mortgage finance in order to recommend what local planners can do to reduce the negative consequences of high-risk home lending for their own communities.

Methods: I plot public and private data, much of it readily available for little or no cost, to discover where in the nation recent mortgage foreclosures are concentrated, and describe how similar analysis could be used prospectively and at a local scale to anticipate future problems.

Results and conclusions: Numbers of subprime, exotic, and zero-down-payment mortgages have all been growing. Where they are spatially concentrated they are linked to rising and geographically concentrated home mortgage foreclosures. I find evidence that subprime lenders achieve greater market penetration in metropolitan areas with less educated residents, and that higher-risk lending is more prevalent where housing prices are high and increasing. I also find that when local housing markets are hot, even high levels of subprime lending are associated with only slightly higher foreclosure filing rates, but foreclosure rates rise quickly when hot markets cool.

Takeaway for practice: Although foreclosures are less likely to be a severe problem in very strong real estate markets, when prices in previously hot markets stagnate or decline, foreclosures can quickly follow. This is a serious concern given recent trends in mortgage financing that have extended credit to more economically vulnerable populations and generally weakening housing markets in many metropolitan areas. These foreclosures tend also to be spatially concentrated within metropolitan areas, particularly stressing housing markets in neighborhoods where the higher-risk products are more prevalent. I recommend that planners: (1) track local lending and foreclosure patterns; (2) promote healthier mortgage markets in vulnerable areas; (3) fund targeted foreclosure prevention and counseling; (4) develop refinancing/restructuring programs; (5) redesign programs to promote sustainable homeownership; (6) get foreclosed properties reoccupied quickly; (7) recognize the effect of foreclosure surges on rental housing markets; and (8) be proactive in policy debates on lending regulation and foreclosure processes.

Research support: None.

Keywords:

• mortgage lending
• subprime mortgages
• zero-down-payment
• foreclosure
• housing

Notes

Note: a. Based on 79 of the 100 metropolitan areas ranked by RealtyTrac. Excludes 21 metro areas with fewer than 1,000 filings in the last 6 months of 2006.

Source: RealtyTrac, Inc. (2006).

1. Teaser rates are initial interest rates that typically run for between 1 and 5 years and are significantly below the prevailing market interest rates for similarly structured loans.

2. In mortgages with interest-only loans, the borrower makes only interest payments (no principal) for some initial number of years. Payment-option loans are those for which the borrower has the option of paying principal and interest, interest only, or some minimum payment that can be less than the interest accrued. For negative amortization loans the regular payments do not equal the accrued interest on the loan, and so the balance owed increases over time. Piggyback loans are second mortgages that allow the borrower to reduce his or her downpayment while avoiding private mortgage insurance. The second mortgage typically carries a higher interest rate. Alt-A loans are low- or no-documentation loans, in which the borrower pays a premium in exchange for not having to provide the usual documents verifying his or her income. For a more detailed description of exotic mortgages, see Fishbein and Woodall (2006).

3. I added the square of the income-to-loan-size ratio after diagnostic plots indicated a nonlinear effect.

4. The change in the proportion of buyers who were Black, the change in the proportion of buyers who were Hispanic, and the change in median loan size, may result from as well as cause changes in the share of a metropolitan area's home purchase loans that are subprime, making these variables potentially endogenous. First, an increased presence of subprime lenders in a region may be expected to increase the number of Black or Hispanic homebuyers, due to their providing more access to credit for Black and Hispanic households than prime lenders. Second, more subprime lending may actually increase the prices of homes by providing borrowers with greater spending power (through higher debtto- income ratios), which in turn can result in a bidding up of housing values. To remedy this, I used a two-stage least-squares technique, first regressing these three endogenous variables on the other independent variables together with three additional instrumental variables I expected to affect the three endogenous variables but not to be significantly affected by the dependent variable. For instrumental variables, I used the 1997 to 2003 change in the metropolitan area's home price index as measured by the Office of Federal Housing Enterprise and Oversight; the change in the proportion of the population that was African American from 1990 to 2000; and the change in the proportion of the population that was Hispanic from 1990 to 2000. In the second stage, I substituted the predicted values of the endogenous variables arising from the firststage regressions, and estimated the main model.

5. Though the median loan size and proportion Hispanic variables are not significant at the .10 level, their t -statistics are not far outside this range given the limited size of my sample.

6. Fannie Mae and Freddie Mac are government-sponsored private businesses, with significant government benefits (e.g., exemption from local taxation, access to low-interest government debt, and an implicit too-big-to-fail expectation in credit markets). They purchase predominantly prime mortgages from lenders, pool them, and issue mortgagebacked securities to provide liquidity to mortgage markets.

7. Nonagency securitization is the process in which mortgages are pooled to create collateral for mortgage-backed securities issued by investment firms other than Fannie Mae or Freddie Mac.

8. The MIRS data omit some significant segments of the mortgage market, including refinance loans, very large loans, loans made by specialized subprime lenders, and in latter years, loans with interest rates below 2.75%, including many ARMs with teaser rates (Congressional Budget Office, 2001). This last omission is particularly relevant in recent years with the advent of exotic mortgages and given the relatively low interest rate environment.

9. Even some public agencies have promoted exotic products as a means of enabling buyers to purchase larger homes. For example, Rhode Island Housing, a public lender, promoted its “Buy More” program as enabling the borrower to qualify “to buy a bigger house, a house in better condition or a house in a more convenient location.” The product is an interest-only loan (Rhode Island Housing, 2006).

10. The maximum LTV ratio on FHA loans varies, but is technically capped at just under 98%. However, some costs and the FHA up-front insurance premium are excluded from this calculation, so that the LTV can effectively exceed 100% on some loans (Berkovec, Canner, Gabriel, & Hannon, 1994.)

11. In 2006, however, the Internal Revenue Service ruled that organizations providing seller-funded assistance do not qualify as tax-exempt charities. The Sacramento-based Nehemiah Corporation of America, the largest of such organizations, is appealing the ruling (Wasserman, 2006).

12. RealtyTrac, Inc. (2006) claims to offer “the largest national database of preforeclosure, foreclosure, for sale by owner, and new home construction properties, with more than 550,000 properties across the country.” It also claims to be rated the fourth largest real estate Web site by Nielsen NetRatings. RealtyTrac includes properties in all three phases of foreclosure: preforeclosures, foreclosures, and real-estate-owned (REO) properties that have been bought back by a bank. The combined report, therefore, overstates the number of properties entering a particular phase of the foreclosure process. However, it appears to be the best source of data for a large number of MSAs, and I expect the data to comparable across MSAs.

13. This excludes mortgages insured or guaranteed by government agencies such as the FHA or VA.

14. Neither of these studies looked exclusively at home purchase loans.

15. Making real estate data generally available does raise privacy concerns. However, I generally advocate that regional planning bodies collect and disseminate only what is already part of the public record, providing it to the public at little or no cost. In most areas data firms already provide such a service, but charge high prices, meaning mortgage brokers and property investors are effectively the only parties able to afford access to these data.

16. Note that some of the recent reforms, particularly those proposed for the Federal Housing Administration, were designed long before the subprime mortgage crisis and are intended mainly to reverse the decline in the FHA's share of the mortgage market.

17. Mortgage lending and foreclosure policy at the state and federal level is a complex topic beyond the scope of this article. For recommendations aimed at improving access to sound and responsible credit and at reducing high and spatially concentrated foreclosures, see Immergluck (2004) and Schloemer et al. (2006).