EconSouth (Third Quarter 2007)
|Scott Frame is a financial economist and policy adviser in the Atlanta Fed's research department.||Housing and the Subprime Mortgage Market|
After years of stellar growth, residential housing and housing finance have slowed markedly in 2007. The press regularly reports significant increases in mortgage foreclosures, especially among borrowers who financed with subprime mortgage loans. These widespread foreclosures, which show few signs of abating in the near future, have repercussions not only for borrowers and lenders but also for neighborhoods, credit availability, and even financial markets.
The house of the rising prices
According to the U.S. Office of Federal Housing Enterprise Oversight, U.S. house prices rose 55 percent between the end of 2001 and the end of 2006. This price appreciation varied greatly from state to state, ranging from 16 percent in Michigan to 112 percent in the District of Columbia.
House price appreciation in the United States can be evaluated by focusing on changes in supply and demand. On the demand side, low mortgage interest rates and steady income growth in most parts of the United States were important drivers. At the same time, supply constraints were especially important contributors to the above-average house price appreciation in the coastal states. And in some areas such as Miami, where prices rose rapidly, speculation likely also pushed prices higher.
Affordability ebbs, ownership rises
The rapid upturn in house prices was accompanied by a decline in housing affordability, even after accounting for income growth and the historically low interest rate environment. Despite this development, U.S. homeownership rates continued to rise, topping out at a record of more than 69 percent at the end of 2004. The natural question is, What explains this unlikely inverse relationship between traditional housing affordability measures (based on a 30-year, fixed-rate, fully amortizing mortgage) and homeownership rates? One important contributing factor is the significant expansion of subprime and other forms of nontraditional, or exotic, mortgage financing.
Subprime mortgages are typically made to individuals with blemished credit histories, high levels of personal debt relative to income, or a high loan amount on property relative to its value. More recently, subprime loans were also being made to borrowers with little or no income verification.
Exotic mortgages are defined by characteristics embedded into the loan contract. These features can include interest-only mortgages (or negative amortization mortgages), pay-option mortgages, and 40-year amortization schedules. Another type that has become prevalent in the subprime environment is the so-called hybrid adjustable rate mortgage (ARM). These mortgages, sometimes referred to as 2/28s or 3/27s, feature fixed rates for an initial period and then move to an adjustable rate tied to a commonly used short-term money market interest rate. Notably, these hybrids also typically carry prepayment penalties during the opening fixed-rate period, greatly reducing the likelihood that the borrower will refinance during that time.
The music stops
In the latter half of 2006, serious delinquencies (defined as those more than 90 days past due or in foreclosure) on subprime mortgages began to rise sharply—a trend that has continued into 2007. Most of these delinquencies have been associated with subprime hybrid ARMs rather than with fixed-rate loans made to similar borrowers.
An important reason behind the increase in subprime hybrid ARM distress is that many of these borrowers took out their mortgages between 2003 and 2005, when short-term interest rates were extremely low. When these mortgages reset higher in 2006 and 2007, borrowers' required monthly payments rose substantially. Some homeowners were then unable to make their payments on time and became delinquent. Many observers are concerned that a large number of similar borrowers have yet to go through the interest rate reset cycle. With little or no house price appreciation likely, these borrowers will be ill-situated to refinance on more favorable terms. These facts suggest a continued drag on housing and mortgage markets.
Another less prevalent yet striking development was the increased underwriting of loans with little or no income verification. Historically, such loans accounted for a small fraction of new mortgages and were largely confined to self-employed people or real estate investors. But in 2006, such loans accounted for more than 13 percent of all new mortgages, according to Inside Mortgage Finance. Many of these loans went into distress almost immediately.
The fallout continues
Mortgage foreclosure is difficult for the affected households, often causing people to lose their homes and their creditworthiness. But when such events occur in large and concentrated numbers, they can also have a significant negative impact on neighborhoods and larger communities. Maintenance on foreclosed homes often suffers, and they are more likely to be converted to rental property.
Notably, the rise in mortgage foreclosures has also had swift and pronounced negative consequences for mortgage financiers. Many of the largest firms specializing in subprime loan originations have shut their doors or have been merged into diversified financial firms. These lenders' business model relied on capital markets purchasing the loans after being packaged into securities. As the quality of the loans deteriorated much beyond expectations, investors have also seen the value of the subprime mortgage securities that they hold plummet. This drop has left many investors questioning the initial ratings of these and other structured securities by institutions such as Moody's, Standard & Poors, and Fitch.
After more than a decade of phenomenal growth, the markets for housing and mortgage finance have cooled, resulting in stagnant or falling home prices in many areas, a significant increase in mortgage foreclosures, the closing of many subprime mortgage lenders, and a substantial revaluation of mortgage securities. These developments have become a drag on U.S. economic growth, the ultimate magnitude and duration of which remain to be seen.