Suburban myths

Sub-prime mortgages have received a lot of attention in the US since 2000, when the number of sub-prime loans being originated and refinanced shot up rapidly. The attention intensified in 2007, when defaults on sub-prime loans began to skyrocket triggering what was known at the time as the 'sub-prime crisis' (Felton and Reinhart, 2008). Researchers, policymakers, and the public have tried to identify the factors within the sub-prime phenomenon that triggered the implosion of the market and eventually the global financial system.

Unfortunately, many of the most popular explanations that have emerged for the sub-prime crisis are, to a large extent, myths. On close inspection, the explanations offered are not supported by empirical research (Demyanyk and Van Hemert 2008; Demyanyk 2009a, 2009b).

Myth: Sub-prime mortgages went only to borrowers with impaired credit

The reality is that sub-prime mortgages went to all kinds of borrowers, not only those with impaired credit. The myth that sub-prime loans went only to those with bad credit arises from overlooking the complexity of the sub-prime mortgage market and the fact that sub-prime mortgages are defined in a number of ways – not just by the credit quality of borrowers.

Specifically, if a loan was given to a borrower with a low credit score or a history of delinquency or bankruptcy, lenders would most likely label it sub-prime. But mortgages could also be labelled sub-prime if they were originated by a lender specialising in high-cost loans – although not all high-cost loans are sub-prime. Also, unusual types of mortgages generally not available in the prime market, such as so-called '2/28 hybrids', would be labelled sub-prime even if they were given to borrowers with credit scores that were sufficiently high to qualify for prime mortgage loans.

The process of securitising a loan could also affect its sub-prime designation. Many sub-prime mortgages were securitised and sold on the secondary market. Securitisers rank pools of mortgages from the most to the least risky at the time of securitisation, basing the ranking on a combination of several risk factors, such as credit score, loan-to-value and debt-to-income ratios, etc. The most risky pools would become a part of a sub-prime security. All the loans in that security would be labelled sub-prime, regardless of the borrowers' credit scores.

Myth: Sub-prime mortgages promoted homeownership

Between 2000 and 2006, approximately one million borrowers took sub-prime mortgages to finance the purchase of their first home. These sub-prime loans did contribute to a slightly increased level of homeownership in the country at the time of mortgage origination. Unfortunately, many home buyers with sub-prime loans defaulted within a couple of years of origination (Demyanyk 2009b). The number of such defaults outweighs the number of first-time home buyers with sub-prime mortgages, negating the homeownership promotion component of sub-prime lending. In short, borrowers really become 'homeowners' if they can hold on to their home, and this was not occurring during the sub-prime years.

Myth: Declines in mortgage underwriting standards triggered the sub-prime crisis

An analysis of sub-prime mortgages shows that within the first year of origination, approximately 10 per cent of the mortgages originated between 2001 and 2005 were delinquent or in default, and approximately 20 per cent of the mortgages originated in 2006 and 2007 were delinquent or in default. This rapid jump in default rates was among the first signs of the beginning crisis.

If deteriorating underwriting standards explain this phenomenon, we would be able to observe a substantial loosening of the underwriting criteria for mortgages originated in 2006 and 2007, vintages that showed extremely high default rates almost immediately. The data, however, show no such change in standards for loans of these vintages.

Actually, the criteria that are associated with larger default rates, such as debt-to-income or loan-to-value ratios, were, on average, worsening a bit every year from 2001 to 2007. However, these underwriting metrics in 2006 and 2007 were not sufficiently different from prior years to explain the nearly 100 per cent increase in default rates just before the crisis.

Myth: Sub-prime mortgages failed because people used homes as ATMs

While home prices were rising and mortgage rates falling, it was common for home equity to be extracted via refinancing for home improvements, bill payments, and general consumption. Though this option was popular throughout the sub-prime years (2001–2007), it was not a primary factor in causing the massive defaults and foreclosures that occurred after both home prices and interest rates reversed their paths. Mortgages that were originated for refinancing actually performed better than mortgages originated solely to buy a home (comparing mortgages of the same age and origination year).

Myth: Sub-prime mortgages failed because of mortgage rate resets

The belief that mortgage rate resets caused many sub-prime defaults has its origin in the statistical analyses of loan performance that were done on two types of loans – fixed-rate and adjustable-rate mortgages – soon after the problems with sub-prime mortgages were coming to light. Results from conventional default rate calculations suggested that adjustable-rate mortgages (ARMs) were experiencing a significantly higher rate of default than fixed-rate mortgages (FRMs).

Such conventional analysis, which considers default rates of all outstanding loans, hides performance problems in FRMs because it combines loans originated in different years. Combining old loans with more recent loans influenced the results. Older-vintage loans tended to perform better, and FRM loans were losing popularity from 2001 to 2007, so fewer loans of this type were being originated every year. When newer loans were defaulting more than the older loans, any newer FRM defaults were hidden inside the large stock of older FRMs. By contrast, the ARM defaults were more visible inside the younger ARM stock.

If we compare the performance of adjustable- and fixed-rate loans by year of origination, we find that FRMs originated in 2006 and 2007 had 2.6 and 3.5 times more delinquent loans within one year of origination, respectively, than those originated in 2003. Likewise, ARMs originated in 2006 and 2007 had 2.3 times and 2.7 times more delinquent loans one year after origination, respectively, than those originated in 2003 (Demyanyk and Van Hemert 2008). In short, fixed-rate mortgages showed as many signs of distress as adjustable-rate mortgages. These signs for both types of mortgage were there at the same time; it is not correct to conclude that FRMs started facing larger foreclosure rates after the crisis was initiated by the ARMs. Also, ARM loans showed high default rates long before resets were scheduled, which indicates that poor performance of these mortgages cannot be explained simply by changing interest rates alone.

Myth: Sub-prime borrowers with hybrid mortgages were offered (low) 'teaser rates'

Hybrid mortgages – which offer fixed rates in the first years and then convert to adjustable rates – were available both in prime and sub-prime mortgage markets but at significantly different terms. Those in the prime market offered significantly lower introductory fixed rates, known as 'teaser rates', compared to rates following the resets. People assumed that the initial rates for sub-prime loans were also just as low and they applied the same 'teaser rate' label to them. The average sub-prime hybrid mortgage rates at origination were in the 7.3 per cent–9.7 per cent range for the years 2001–2007, compared to average prime hybrid mortgage rates at origination of around 2–3 per cent. The sub-prime figures are hardly 'teaser rates', even if they were lower than those on sub-prime fixed-rate mortgages.

Have we learnt our lesson?

Many of the myths presented here single out some characteristic of sub-prime loans, sub-prime borrowers, or the economic circumstances in which those loans were made as the cause of the crisis. All of these factors are certainly important for borrowers with sub-prime mortgages in terms of their ability to keep their homes and make regular mortgage payments. But no single factor is responsible for the sub-prime failure.

In hindsight, the sub-prime crisis fits neatly into the classic lending boom and bust story – sub-prime mortgage lending experienced a remarkable boom, during which the market expanded almost sevenfold over six years. In each of these years between 2001 and 2007, the quality of mortgages was deteriorating, their overall riskiness was increasing, and the pricing of this riskiness was decreasing (see Demyanyk and Van Hemert 2008). For years, rising house prices concealed the sub-prime mortgage market's underlying weaknesses and unsustainability. When this veil was finally pulled away by a nationwide contraction in prices, the true quality of the loans was revealed in a vast wave of delinquencies and foreclosures that continues to destabilise the US housing market even today.

Kent Cherny is a research assistant in the Research Department of the Federal Reserve Bank of Cleveland

Yuliya Demyanyk is senior research economist in the Research Department of the Federal Reserve Bank of Cleveland

Originally published on www.VoxEU.org. Reproduced with permission.