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Subprime loans can be defined as loans to borrowers who do not qualify for the prime rate, either because they have a blemish on their credit history, or they may be a bad risk despite perfect credit history.  In order to justify lending to riskier borrowers through the subprime market, these loans carry higher interest rates.

 

Indicators of inefficiency in subprime market

 

The Fannie Mae paper discusses three indicators of market inefficiency in the subprime market.

First, ideally, subprime lending charging higher interest rate and fees should be justified by perceived higher risks of the borrowers ex ante by the underwriters. If it is found that borrowers are not allocated between subprime and prime market for reasons other than risk, there is concern for market inefficiency.

Empirical evidence with risk-only model shows that the subprime borrowers exhibit a consistent pattern in correlation with ex ante risk indicators including LTV ratio/FICO scores, Income/Payment ratios, and product type and loan purpose. Expanded model further shows that certain non-risk factors are also significant in explaining the allocation of subprime borrowers, such as age, level of education, being asked to pay off debts, being turned down by a lender, being less familiar with mortgage types, searching little for the best rates, and responding to an offer of guaranteed loan approval. Non-risk factors that do not have a significant impact on the probability of entering subprime market include race/ethnicity, gender, first-time owner status, financial attitudes and control, or any neighborhood characteristics. Conclusively, risk is the single most important determinant of why borrowers end up with subprime loans, while certain non-risk factors also have an impact, indicating inefficiency.

Second, if it is found that borrowers’ satisfaction with mortgages and services they received from the subprime lender is significantly low, indicating reduced efficiency relative to the prime market.

A survey of borrowers shows that subprime borrowers are dramatically less satisfied with the service they receive from the lenders than prime borrowers are, on account of perceived fairness of loan term and actual experience against expectation. This indirect evidence of low satisfaction among subprime borrowers is another indication of inefficiency.

Third, the difference between subprime and prime market interest rates should be justified by the costs of bearing higher risks by the subprime lenders. If it is found that the interest rate gap is larger than explained by costs associated with higher risks, it indicates market inefficiency.

Analysis comparing two pools of mortgages scored A- by Freddie Mac from subprime and prime lenders shows an average difference of 215 basis points in interest rates. Controlling for the heterogeneity of A- loans only account for roughly 90 basis points. Controlling for the higher servicing cost only accounts for an additional 25 basis points. It appears that 100 basis points in the interest rate premium paid by subprime borrowers could not be explained by higher level of risk associated with those loans. Moreover, the higher fees paid by subprime borrowers are not yet even taken into consideration. This finding also suggests possible inefficiency in the subprime sector.

 

Why predatory loan features might in theory undermine market efficiency

 

Predatory lending can occur outside the real estate market, but it is particularly troublesome in the subprime mortage market.  According to the GAO, “It is widely accepted that the overwhelming majority of predatory lending occurs in the subprime market.” Predatory lending in this market is even harder to pin down because unlike prime loans, the pricing of subprime loans varies, making it hard to discern whether fluctuations in subprime loan pricing is due to legitimate exogenous variables or due to predatory distortions.

One of the difficulties in evaluating the effects of predatory lending is that the judgment-charged term needs an accurate definition.  Furthermore, the extent of these so-called predatory lending characteristics muddles the definitions.  In its comprehensive report on predatory lending in 2004, the Government Accountability Office identified some common traits in loans to associate with predatory lending: prepayment penalties, balloon payments, and low documentation. 

One reason that lenders would include prepayment penalties in a loan is to lower information asymmetries.  Prepayment penalties enhance the expectation of borrower reliability.  Without prepayment penalties, the borrowers have the choice of refinance or making faster repayments, increasing the uncertainty of payment stream.

A long prepayment penalty for mortgage borrowers might be suboptimal because it limits the ability of the borrower to refinance under better loan terms if their risks improve over time or if they later find their loan terms abusive. Lehman Brothers data show that 52.7% of the borrowers prepay on loans with prepayment penalties during the five-year lock-out period (CRL Policy Paper No. 4, 3).  Prepayment penalties are very costly and usually involve giving up 5% or more of the home equity, so why it is the case that borrowers took the loan in the first place?

First, it could be that many of those borrowers have improved their credit scores and/or earned a higher income, so they become qualified for prime mortgages. Prepayment penalties locked them in the subprime contract and it is costly for them to refinance under better loan terms. It causes inefficiency to the market because borrowers are not accurately allocated between prime and subprime market.

Second, it could be that those borrowers become unsatisfied with their loan terms and services due to failure to exert enough effort at loan origination. Later, when they discovered those aspects and want a way out, they can only make an expensive exit with prepayment penalties. For example, in the context of teaser rates, borrowers are hoaxed into taking the loan, only later to find out the spike in rates for the remainder of the loan term. This also creates inefficiency in the market by increasing borrower dissatisfaction and causing higher interest rate in subprime market than explained by risks.

On the other hand, prepayment penalties may create an incentive for the borrowers to seek out the best loan terms available on the market, because it is made more costly to cash out. So the reverse might be true that prepayment penalties actually increase market efficiency.

Another commonly defined predatory lending feature is the “balloon payment”.  In most loans, the periodic payments are calculated such that when the mortgage matures, the outstanding balance on the loan is fully amortized.  However, in a loan with a balloon payment, the periodic installments are less than the fully amortizing amount, so there remains a balance to be paid once the loan matures.  Again, this is not abusive per se; for those borrowers who expect smaller income in the short term but larger income in the long term, the balloon payment might help them finance a better deal than the traditional mortgage.  That said, borrowers facing a balloon payment have the risk of failing to come up with the sizable funds at maturity. This risk might be exacerbated by information asymmetry, such as when lenders have incomplete information of the borrowers’ financial risk, or when borrowers have incomplete appreciation of the loan terms.  It might cause distortion of loan rates in this context and lead to market inefficiency.

Low/no documentation are used by many borrowers and brokers as a means to get around the income/employment certificate or credit history requirement if the borrowers have non-traditional source of income. Since brokers take a fee from every origination without consideration of the quality of the loan, brokers have an incentive to maximize the number of origination, even for borrowers who have little chance of repaying.  In this case the low/no documentation lead to market inefficiency by increasing subprime foreclosures.

Many popular media also points to ARM as predatory. Many subprime mortgages are adjustable rate mortgages; the interest rate can change according to a group of indicators.  The foreclosure start rate for subprime ARMs increased dramatically from 2006 to midway through 2007.[1]  This is not to suggest that adjustable interest rates are predatory by definition.  However, interest rates that are high to begin with because of the inherent risk of subprime lending, combined with variance in the costs to borrowers can be harmful to borrowers.  Furthermore, certain types of ARM features are especially vulnerable to predatory lending practices.  One in particular is the Hybrid ARM, in which the interest rate is fixed and somewhat low for an introductory period; after that, the rate shifts to an adjustable rate for the remainder of the loan.  A common practice in the subprime market is a 30-year “2/28 loan”—the interest rate is fixed for two years and then moves to a variable rate for the last 28 years.[2]  “hybrid ARM” sounds professional and legitimate, but that early fixed rate goes by the name “teaser rate” as well.  A low fixed interest rate can be used to entice potential borrowers into a loan; the higher rates to be paid once the hybrid ARM resets to the adjustable rate are less obvious to borrowers, particularly if a mortgage broker makes great efforts to overstate the teaser rate and understates the variable rate.  The transition to the adjustable rate can lead to a “payment shock” for borrowers who did not anticipate the increased payments after the teaser rate.

 

Observed impact of predatory loan features on subprime foreclosures

 

Rose (2007) examines the impacts of predatory lending practices on subprime foreclosures across FRM/ARM and Purchase/Refinance loan categories. Using data on subprime refinance and purchase mortgages from the Chicago metropolitan area, Rose examines the impact of long prepayment penalty periods, balloon payments and reduced documentation on the probability of foreclosure.

There are certain limitations in Rose’ research. The data only include loans originated in Chicago metropolitan area from the start of 1999 through mid-2003. The narrow geographic range necessarily limits the regional economic, legal and many other factors that may affect the distribution of foreclosure rates, but also limits the number of loans. The short time period lead the results to be reflective of only short-term performance, because the loans are relatively unseasoned. Over the long-term the distribution of foreclosure rates might be different. Also, some potentially important non-traditional mortgage types are not represented.  One example is payment option loan, giving the borrower much flexibility in monthly payment. The borrower could choose to make minimum due payment, fully amortizing payment, or interest only payment. Those mortgage types have become widespread only more recently.

The result shows that the multitude and direction of impact of predatory lending features on foreclosure rates depends significantly on the loan category and combination of those features.  Loans in different categories and loans with a given combination of loan features may require different treatment.

The negative correlation of long prepayment penalty periods with refinance FRM is inconsistent with the popular notion that prepayment penalties cause more foreclosures. It suggests that prepayment penalties could play a useful role in reducing foreclosures. One theory is that some borrowers use prepayment penalties to signal their actual better ability to repay than their credit history suggests, and as a result get a lower interest rate for their perceived lower risk. Those borrowers tend not to apply for low/no documentation because they actively seek to prove their creditworthiness. This conjecture is consistent with the fact that co-existence of low/no documentation and long prepayment period is dominantly correlated with increase in foreclosure rates. The negative relationship between prepayment penalties and loan interest rates also corroborates this theory.

Balloon payment per se is not a cause of the increased foreclosure rates in this study, as all loans have not reached the balloon payment due date. This suggests that restricting the use of balloon payments would not address the underlying cause of the increase in foreclosure.

Low/no documentation for refinances is associated with significantly increased foreclosure rates, whereas for purchase FRMs it is associated with decreased foreclosure rates, and it has not much impact on purchase ARMs. This suggests that loosening information requirement of borrowers significantly contribute to increase in foreclosure for refinances, but not for purchases.

This suggests that relationships among predatory loan features and foreclosures are much more complex than popular notions presume, casting doubt on regulators’ current ability to distinguish between abusive and non-abusive lending. In particular, broad prohibitions or restrictions of these loan features that do not distinguish among loan categories are likely to cause unintended and undesired consequences.

 

Observed impact of anti-predatory lending laws on subprime lending

 

In theory anti-predatory lending laws could have a dual impact on the supply and demand of subprime credit. It may depress the supply and demand if the borrowers and lenders find the law imposing too many restrictions and significantly increasing the cost of borrowing/lending. For instance, laws prohibiting the use of low/no documentation may discourage borrowers who cannot produce traditional employment/income certificates because they are seasonal workers or small business owners and have unsteady income stream. Passage of such law may reduce demand of those borrowers. But it also may boost supply and demand if the borrowers and lenders find the law making borrowing/lending less risky and overtaking the downside associated with those restrictions. For example, absence of APLs may lead some borrowers to fear falling victim of twisted lenders. Passage of a law may reduce these fears and actually stimulate demand.

There are three dimensions to the APLs, coverage, restriction and enforcement. Coverage refers to the range of loans that is subject to regulation by APL. Restriction refers to the legal rules limiting predatory loan features and regulating lending practices. Enforcement refers the means by which APLs are enforced through public or private redress.

In 1994, Congress enacted the first modern, comprehensive anti-predatory lending statute, the Home Ownership and Equity Protection Act (HOEPA). A study by the Office of Thrift Supervision concluded that HOEPA covers no more than 5% of subprime residential mortgages, which are deem “high-cost” by exceeding the legal triggers. For those loans, HOEPA imposes substantive restrictions on lending terms and practices.

 To redress predatory lending, “mini-HOEPA” laws have been adopted by many states starting in the late 1990s. The mini-HOEPA laws display considerable variations. Most cover broader range of loans than HOEPA, with legal trigger lowered or more loan types included. Restrictions imposed by those laws vary widely, from prohibiting the use of a certain predatory loan feature to limiting its term to various degrees. Enforcement also varies considerably, with some laws only providing for government intervention, while others giving the injured party the right to sue for compensatory and even punitive relief.

Li and Ernst (2006) find that APLs reduce predatory loan terms without reducing originations in most states compared with unregulated states. Nominal interest rate stayed level or dropped in most states with APL. Ho and Pennington-Cross find that APLs had no effect on the probability of origination and only a scant negative effect on the probability of application, while reducing the likelihood of being rejected.

Reduced loan terms and interest rate without reducing originations in states with APL suggest an increase in efficiency, since the unexplained interest rate gap between subprime and prime market is narrowed. Reducing the rejection rates without reducing origination rates also suggest an increase in efficiency from reduced transaction costs, since it saves those borrowers who potentially would have been rejected the cost of applying for the loan and it saves the lenders the cost of processing those applications.

Bostic’s results show that while considered in aggregate, APLs have little impact on subprime originations, applications or rejections, the components of legal framework are important in understanding the true dynamics. More restrictive state laws reduce subprime originations, increase subprime rejection, and reduce application likelihoods. Laws with broader coverage are associated with increased subprime origination, reduced rejection, and increased application. Since the effects of restriction and coverage seem to be pulling in opposite directions, the overall impact of a given APL on subprime market is not obvious. Also, the evidence that laws with broader coverage lead to an increased probability of applications is consistent with a reverse lemons hypothesis, which argues that a legal framework can stimulate creditworthy applicants who had opted out of the market to apply for loans.

 

Conclusions

In popular notion, certain loan features are often characterized as predatory, with the assumption that they would uniformly drive up foreclosure rates under most circumstances.

Reality is more complex, however. Any proposal to address rising foreclosure rates through a blanket ban or restriction on particular loan features would not have much success. Narrower focus on specific category of loans and the interaction among those loan features is necessary.

The opposing effect of restriction and coverage of APL points to the need for additional research. Questions remain as to how enforcement, the third component of legal framework, interacts with restriction and coverage in shaping subprime market outcomes. Effective legislation hinges on fine-tuning those components of legal framework to achieve maximum efficiency.

 

Bibliography

Raphael W. Bostic, Kathleen C. Engel, Patricia A. McCoy, Anthony Pennington-Cross, Susan M. Wachter, State and local anti-predatory lending laws: The effect of legal enforcement mechanisms, Journal of Economics and BusinessVolume 60, Issues 1-2

Morgan J. Rose, Predatory lending practices and subprime foreclosures: Distinguishing impacts by loan category, Journal of Economics and BusinessVolume 60, Issues 1-2

Government Accountability Office.  Home Mortgage Defaults and Foreclosures: Recent Trends and Associated Econo ic and Market Developments.  Briefing to the Committee on Financial Services, House of Representatives.  10/10/2007.

“Subprime Lending:  An Investigatino of Economic Efficiency.”  Housing Policy Debate.  Vol. 15, issue 3.  Washington, DC: Fannie Mae Corporation, 2004.

Goldstein, Debbie and Stacy Strohauer Son.  “Why Prepayment Penalties are Abusive in Subprime Home Loans.”  Center For Responsible Lending, policy paper No. 4.  4/2/2003.