The financial institutions that bear the credit risk in mortgage lending are critical because without such participants, mortgages cannot be made. Once an institution agrees to assume the risk that a borrower will not repay a loan as scheduled, the other participants in the mortgage process--originators, funders, and purchasers--are readily available. The bearing of credit risk is an ongoing concern of the mortgage market and the government, and a variety of institutions have evolved for that purpose. The performance of these institutions in taking on credit risk has important public policy implications because home ownership, particularly within lower-income and minority communities, is a well-established national goal and is of intense public interest.
Assessing the performance of mortgage market participants in accepting credit risk is not straightforward for several reasons--lack of data, uncertainties about the most appropriate criteria for assessing performance, and the influence of government subsidies and regulations. The diversity of the participants' goals and strategies also complicates the task: The government mortgage insurers that account for most of the risk-bearing activity in the government mortgage system are nonprofit and accept nearly all the credit risk of the mortgages they insure; the mortgage originators, insurers, and purchasers that make up the conventional mortgage system are profit-seeking and generally act to spread the risk throughout the system.
In an earlier study we assessed the performance of the major participants in the market for home purchase mortgages by examining the distribution of the mortgage credit risk borne by these institutions.(1) For that analysis we combined 1994 data on mortgages collected pursuant to the Home Mortgage Disclosure Act (HMDA) with 1994 data on private mortgage insurance (PMI) activity made available by private mortgage insurers. With that unique database we obtained rough measures of the amount of credit risk that the major participants bore and the distribution of that risk across institutions by the income and racial or ethnic characteristics of the borrowers and their neighborhoods. We found that the largest government insurer, the FHA, was the most involved with lower-income and minority homebuyers, as measured by both portfolio share (the proportion of an institution's own mortgage portfolio extended to these groups) and market share (the proportion of all mortgages extended to these groups for which an institution bears the credit risk). Depository institutions generally had higher portfolio and market shares than the two for-profit government-sponsored enterprises that are active in the secondary market, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
In this article we revisit the issue of who bears the credit risk associated with mortgage lending using 1995 data and refined estimates of the amount of mortgage credit risk borne by market participants.(2) In our earlier analysis we measured credit risk in terms of the number of mortgages held or insured; here we go beyond looking at numbers or simple dollar amounts of mortgages held or insured and instead measure risk in terms of the dollar losses that could be expected on the basis of historical experience.
Institutions' expected dollar losses are determined primarily by the distribution of loan-to-value ratios within their mortgage portfolios: Higher ratios are associated with higher mortgage default probabilities and loss severity rates. Data on these aspects of mortgage lending are not reported under HMDA and are not readily available elsewhere; we obtained the information in a variety of ways, including discussions with industry participants and modeling based on preliminary data from the Federal Reserve's 1995 Survey of Consumer Finances.
Who bears the credit risk for mortgage lending to lower-income borrowers, black or Hispanic borrowers, lower-income neighborhoods, and minority neighborhoods, and how is that risk distributed? The findings based on our refined estimates of credit risk are in accord with our earlier results: In terms of market share, the FHA, the largest institution in the government mortgage system, outperforms all other institutions or types of institutions. It is the major bearer of credit risk for these groups. For example, the FHA backed about one-third of the dollar amount of mortgages extended in 1995 to lower-income borrowers but assumed nearly two-thirds of the credit risk associated with lending to that group.
The market shares of the conventional mortgage system are not only small relative to the amount borne by government institutions; they are also broadly distributed across the major types of institutions in the system. No single institution or set of institutions stands out as a principal bearer of credit risk for the conventional mortgages extended to these borrowers.
The FHA also has a high portfolio share for lending to lower-income or minority borrowers and neighborhoods relative to the participants in the conventional mortgage system. However, some profit-seeking portfolio lenders devote a large share of their portfolio risk to lower-income borrowers and neighborhoods. These lenders--commercial banks, savings associations, and mortgage banks--have low-income portfolio shares similar to the FHA's, although their market shares are only slightly larger than those of others in the conventional mortgage system.
THE MANAGEMENT OF MORTGAGE CREDIT RISK
The credit risk associated with mortgage lending is managed in a variety of ways, mainly by the use of underwriting standards and the sharing of risk among participants in the mortgage market, including borrowers. Because different groups of borrowers have different credit characteristics, the risk-management approach taken may affect the distribution of mortgage borrowers across income groups, race and ethnic categories, and neighborhoods.
Requiring borrowers to meet certain underwriting standards is the most important step lenders take to manage mortgage credit risk. In assessing the possibility that a prospective borrower may default on a mortgage, lenders evaluate both ability and willingness to repay the loan. They look at sources of income, debt-payment-to-income ratios, assets, employment history, and prospects for income growth. They also review the applicant's credit history and estimate the value of the property for which the mortgage is being sought.
Varying the price of credit by charging riskier borrowers higher interest rates is another means of managing credit risk. Lenders know, for example, that the probability of default, as well as the extent of the loss resulting from default, is strongly related to the loan-to-value ratio of the mortgage: The higher the ratio, the greater the likelihood of default and the larger the potential loss.(3) To compensate for greater risk, lenders may require a borrower who takes out a mortgage having a high loan-to-value ratio to pay a higher interest rate (or, more often, to purchase mortgage insurance, which raises the effective interest rate). They may also price the mortgage according to other characteristics that may influence its riskiness; for example, they may charge higher interest rates on longer-term loans.
The sharing of credit risk is common within the home mortgage industry. First and foremost, lenders share risk with the borrower by requiring the borrower to make a down payment toward the purchase of the home. The larger the borrower's equity stake, the more the value of the home exceeds the loan balance, providing the lender with a greater cushion in case of default.
Credit risk is also shared among institutional participants in the mortgage market. For example, lenders usually require a borrower to purchase mortgage insurance from a public or private mortgage insurer if the down payment is less than 20 percent of the home's appraised value.(4) Lenders also often sell mortgages in the secondary market under terms that relieve themselves of the credit risk associated with the mortgage (that is, the secondary-market institution has no recourse to the seller in the event of default).
Credit risk can also be managed by influencing the probability of default and the extent of losses associated with default. Lenders use a variety of risk-management techniques to encourage timely repayment. For example, they may require a prospective borrower to receive credit counseling or homebuyer education before taking out a mortgage and may work more aggressively with a borrower who becomes delinquent. To lower the losses associated with default, lenders may encourage a seriously delinquent borrower to sell the home before foreclosure (a so-called short sale), thereby avoiding the legal expenses and other costs associated with the often-lengthy foreclosure process. Other methods of loss management include allowing delinquent borrowers to defer payments until their financial circumstances improve and modifying loan agreements.(5)
THE MAJOR PARTICIPANTS IN THE MORTGAGE MARKET
During the past sixty years, the Congress has created public institutions--and has both granted advantages to and imposed restrictions on private institutions--to influence underwriting standards and other aspects of mortgage lending and, thus, the level and composition of mortgage activity. In recent years, congressional actions have focused on encouraging the provision of mortgage credit to lower-income and minority homebuyers and to those seeking to purchase homes in lower-income neighborhoods and central cities. These actions influence the distribution of credit risk among the participants in the mortgage market.
The Nonprofit Government Mortgage System
The Congress has established nonprofit government institutions to promote home ownership among specific groups and in the population at large. Of the nonprofit government institutions, the FHA and the VA have by far the largest home loan programs. Their missions are to promote home ownership by insuring mortgages extended, respectively, to lower- and moderate-income homebuyers and to veterans.(6) Subsidization by the federal government helps these agencies achieve their goals.(7) The FHA plays a larger role in the mortgage market than the VA.
The FHA's activity is limited by the Congress in several ways: by size limits on the mortgages that it can insure, by restrictions on its ability to change insurance premiums, and by limits on the aggregate amount of insurance that it may write each year. The FHA relies on the insurance premiums paid by lower-risk borrowers to cross-subsidize the costs imposed by higher-risk borrowers.(8) Consequently, because private mortgage insurance may cost less, lower-risk borrowers who qualify for privately insured loans tend not to use FHA programs.(9)
A higher proportion of lower-income borrowers than of higher-income borrowers choose mortgages insured by the FHA or the VA. Under these programs, prospective borrowers can qualify for credit with more debt relative to income, with smaller down payments, and with weaker credit histories because the underwriting standards of the FHA and the VA are generally less strict than those used by private mortgage insurers. Many families with lower incomes need the more relaxed underwriting guidelines to qualify for mortgages because they tend to carry relatively higher loads of nonhousing debt, to have fewer assets to draw on when making down payments and paying closing costs, and to have histories of credit problems or no credit histories at all. At the same time, upper-income borrowers tend to seek mortgages that exceed the limits on the size of mortgages eligible for FHA insurance or that receive proportionally less backing from the VA, thus reducing their participation in these programs.
Like lower-income borrowers, black and Hispanic borrowers tend to use FHA and VA mortgages relatively often. On average, borrowers in the latter group, compared with their white or Asian counterparts, have lower incomes, less wealth, weaker credit histories, and less-stable employment, and they purchase homes with lower values. In addition, black and Hispanic borrowers are more likely than equally qualified white and Asian borrowers to choose FHA-backed mortgages.(10)
A third nonprofit government institution, the Government National Mortgage Association (Ginnie Mae), is active in the secondary mortgage market; it was created by the Congress to provide liquidity solely for federal housing initiatives. In contrast to other secondary-market institutions, which buy mortgages and sell securities backed by mortgages, Ginnie Mae does not purchase mortgages. Instead, Ginnie Mae guarantees the timely payment of interest and principal for privately issued securities backed by mortgages insured by the FHA or the VA. In our analysis we do not identify Ginnie Mae as a bearer of credit risk; instead, we assume that the entire …