Growth of Subprime Mortgage Market Raises Questions
The recent emergence and rapid growth of subprime mortgage lending—making loans to people with weak credit histories—have helped to make home ownership accessible to many people who previously could not qualify for a home loan. That growth, in turn, has helped boost the nation’s home ownership rate to unprecedented levels.
New types of risk
But the surge in subprime mortgages is also creating new forms of risk to subprime borrowers, holders of securities backed by subprime mortgages, and potentially the wider marketplace of housing finance. Observers, regulators, and markets don’t yet fully understand the risks because the phenomenon is new, said Robert A. Eisenbeis, executive vice president and director of research at the Atlanta Fed.
The risks stem mainly from the nature of subprime mortgages: Most are two- or three-year adjustable rate mortgages (ARMs) tied to short-term benchmarks such as the London interbank offered rate (LIBOR), a widely used standard in real estate lending. In fact, 66 percent of the subprime mortgages that were purchased and packaged into mortgage-backed securities in 2004 were two-year ARMs, and another 19 percent were three-year ARMs, according to Lehman Brothers and the Federal Housing Finance Board.
Rising rates heighten risk
Consequently, beginning in 2006 and continuing through at least 2014, the rates will reset on at least 60 percent of subprime mortgages. Most analysts believe subprime borrowers face long odds against ARM rates declining.“If history is any guide, it is unlikely that mortgage interest rates will drop further,” Eisenbeis said.
Since the general trend recently has been rising rates, most subprime mortgage holders—who tend to be less affluent than prime borrowers—will likely see their monthly payments increase next year. Such increases heighten the risk of foreclosures and a corresponding deterioration in the quality of the subprime loans that underlie mortgage-backed securities (MBS). Roughly $420 billion–$430 billion in subprime MBSs were issued in 2004, according to Lehman Brothers and Inside MBS & ABS.
A concern for the MBS market is the question of who owns subprime MBSs, Eisenbeis said, and who is liable for those mortgages in the event of a default.