On the Economics of Subprime Lending

US mortgage markets have evolved radically in recent years. An important part of the change has been the rise of the subprime market, characterized by loans with high default rates, dominance by specialized subprime lenders rather than full-service lenders, and little coverage by the secondary mortgage market. In this paper, we examine these and other stylized facts with standard tools used by financial economists to describe market structure in other contexts. We use three models to examine market structure: an option-based approach to mortgage pricing in which we argue that subprime options are different from prime options, causing different contracts and prices; and two models based on asymmetric information–one with asymmetry between borrowers and lenders, and one with the asymmetry between lenders and the secondary market. In both of the asymmetric-information models, investors set up incentives for borrowers or loan sellers to reveal information, primarily through costs of rejection.     

Subprime Borrowers: Mortgage Transitions and Outcomes

Public policy concerns increasingly have focused on subprime lending. Our research uses a survey of prime and subprime borrowers to address whether borrowers inappropriately are channeled to the subprime segment, if once having taken out a subprime mortgage borrowers are stuck in this market segment, and whether borrowers face higher costs by taking out subprime mortgages. We find that subprime borrowers are less knowledgeable about the mortgage process, are less likely to search for the best mortgage rates, and are less likely to be offered a choice among alternative mortgage terms and instruments—possibly making them more vulnerable to unfavorable mortgage outcomes. Our analysis of market segmentation confirms that typical mortgage underwriting criteria are most important in explaining whether borrowers obtain prime or subprime mortgages—higher credit risk borrowers are more likely to get a subprime loan. Our results further show that search behavior and other demographic factors including adverse life events, age, and Hispanic ethnicity contribute to explaining market segment, suggesting that borrowers may inappropriately receive subprime mortgages. While we find some persistence to market segment—borrowers are more likely to take out a subprime mortgage if their previous mortgage came from the subprime segment—we also find that market segment is not immutable. Analysis of the survey responses indicates that borrowers with subprime mortgages significantly are more dissatisfied with their mortgage outcomes. This is not surprising because subprime borrowers look worse across typical mortgage underwriting criteria. Consistent with policy concerns, however, despite holding constant these and other factors, taking out a mortgage in the subprime segment, by itself, appears to increase dissatisfaction with mortgage outcomes. We do not provide a definitive answer to the question of whether subprime lending, on balance, serves homebuyers well by providing access to mortgage credit to those otherwise constrained, or rather serves homebuyers poorly by inappropriately assigning them to a market where costs are high and the ability to transition to more attractive prime mortgages remains low. Our analysis, however, does provide some empirical support for concerns raised by critics of subprime lending, and for this reason justifies continued public policy debate and analysis.     

Banks as Interest Rate Managers

Most banks have a two-tier pricing system, offering accounts at market-related interest rates and at posted rates that are changed at discrete intervals. In this paper, I develop a model of bank interest rate management. I consider a bank with two classes of loans and deposits in its balance sheet: One pays a market rate of interest, the other a posted rate. Market rates are exogenous and evolve stochastically over time. Posted rates are altered intermittently by the bank itself. The bank faces imperfect arbitrage by its customers between posted and market rate funds. Under simple assumptions about the stochastic process governing the market rate, I derive optimal decision rules for the adjustment of the posted rate and determine conditions under which these rules are asymmetric. A key prediction of the model is a negative correlation between market loan rates and the gap; this is more consistent with the behavior of British banks than is the contrary prediction of more standard models.     

Interest-only and principal-only mortgage strips as interest-rate contingent claims

Interest-only (IO) and principal-only (PO) mortgage strips are valued in a stochastic interest-rate environment. The prepayment rate of the underlying mortgages is affected by two considerations not present in the pure financially rational model: (1) The property owner's holding period is assumed to follow a Gamma distribution, resulting in the possibility of prepayment due to the sale of the property (i.e., prepayment that is too early based on market interest rates); and (2) borrowers are assumed to face heterogeneous transaction costs related to refinancing the existing mortgage, and delay refinancing when market conditions make it optimal to do so (refinancing too late). Properties of IO/PO strips are identified by the finite difference method.     

Do mortgage rates vary based on household default characteristics? Evidence on rate sorting and credit rationing

Credit screening models suggest that lenders vary loan rates and debt ceilings across applicants on the basis of credit risk. We argue that regulatory constraints such as Fair Lending Laws may preclude rate sorting while increasing lender use of debt ceilings to adjust for applicant credit risk. Using household data from the 1983 SCF, we find that mortgage rates do not vary with applicant credit risk whereas related studies find that debt ceilings vary with borrower risk attributes. Together, these findings support arguments that regulatory constraints reduce rate sorting while increasing the use of non-price terms in the mortgage contract.     

A RECONSIDERATION OF DISCRIMINATION IN MORTGAGE UNDERWRITING WITH DATA FROM A NATIONAL MORTGAGE BANK

This paper, analyzing over 12,000 conventional and FHA/VA loan applications to a national mortgage lender in the 1989–1990 period, argues that mortgage denials occur only in a minority of cases, where the borrower has not learned the lender's underwriting rules in advance. Widespread borrower foreknowledge of such rules is demonstrated by a discriminant finding that 9 of 10 borrowers correctly choose whether to apply under FHA vs. conventional programs, based on financial and equity characteristics. This contrasts with the far lower ability of econometric models to identify approval/denial outcomes. It is revealing that denials on the basis of credit problems, the only important information generally not available until post application, account for most racial/ethnic differences and borrower education affects the probability of approval of government insured loans more than loan to value. Contrary to common assumptions, race differences in FHA/VA lending a re at least as pronounced as in conventional lending; and outcomes for Asians, correctly measured, diverge as much from outcomes for whites, as do outcomes for Hispanics and African American.     

Loan Portfolio Swaps and Optimal Lending

Theories on loan portfolio swap hedging are based on a portfolio-choice approach. This paper presents an alternative: a firm-theoretic model for bank behavior with loan portfolio swaps. Our paper derives the optimal loan rate and rate-taking loan amount of the banks portfolio, and relates them to the market loan rate, counterparty loan rate, swap default risk, capital-to-deposits ratio, and deposit insurance. We find that in the bilateral default risk approach, the comparative static results are generated by four factors: the banks risk magnitude about the equity market value, loan composition in the swap contract, the substitution effect in the loan portfolio, and the income effect from the swap transaction. The results imply that changes in the payoff asymmetry in the event of swap default and the banks regulatory parameters have a direct effect on the banks loan portfolio for lending and swap transactions.We would like to thank two anonymous referees for helpful comments and advice.     

Financial Distress and Bank Restructuring of Small to Medium Size UK Companies

We use a unique data set to study how U.K. banks deal with financially distressed small and medium-sized companies under a contractualist bankruptcy system. Unlike in the U.S., these procedures limit the discretion of courts to strict enforcement of debt contracts, without any dilution of creditors claims. We show that lenders and borrowers select a debt structure that avoids some of the market failures often attributed to a contractualist system. Collateral and liquidation rights are highly concentrated in the hands of the main bank, giving it a dominant position in restructuring or liquidating a defaulting firm. There is little litigation, and no evidence of co-ordination failures or creditors runs. However, there is some evidence that the banks dominance makes it lazy in monitoring, relying heavily on the value of its collateral in timing the bankruptcy decision.     

Cultural Affinity and Lending Discrimination: The Impact of Underwriting Errors and Credit Risk Distribution on Applicant Denial Rates

We examine the impact of underwriting errors on marginal loan denial rates when these errors or average creditworthiness differ across racial groups. We find that the noise in evaluating applicant credit risk can have a differential impact on marginal borrowers across racial groups. Consequently, discrimination can go undetected in an examination of relative loan denial rates when it is present. We also show that discrimination can be detected where none exists. Furthermore, we argue that it is likely that the errors a bank makes in assessing applicant credit risk are a consequence of its skill or affinity, which, in turn, is shaped by the underwriting experiences in the bank's market. A resulting implication is that banks that develop affinities in serving different market segments may have substantially different denial rate experiences across racial groups. This observation can shed light on the puzzling result that minority-owned banks tend to perform poorly in studies of lending discrimination. We conclude that underwriting errors call into question the reliability of the fair-lending guidelines used to assess all banks.     

Institutional disparities in the pricing of adjustable rate mortgage loans

In recent years, commercial banks and savings and loan associations in South Florida have consistently offered initial adjustment period teasers, or subsidies, on their adjustable rate mortgage loans (ARMs). This study adopts the size of the initial subsidy as a proxy for a lender's willingness to offer ARM loans and develops an econometric model which relates the size of the teaser to a series of internal variables (other lending parameters), and external variables (financial market conditions).The results suggest that subsidization policies are not identical across institutions. Specifically, savings and loan associations seem to be less willing than commercial banks to accept the interest rate exposure inherent in ARM lending when future loan rates are constrained by adjustment limits. Consequently, the study argues that the character of a lender's existing assets influences its reactions to the risk/return properties of new assets.This paper has benefitted greatly from the comments of the Journal's reviewers. Responsibility for remaining errors rests with the author.