Ten Myths about Subprime Mortgages

Article excerpt

On close inspection, many of the most popular explanations for the subprime crisis turn out to be myths. Empirical research shows that the causes of the subprime mortgage crisis and its magnitude were more complicated than mortgage interest rate resets, declining underwriting standards, or declining home values. Nor were its causes unlike other crises of the past. The subprime crisis was building for years before showing any signs and was fed by lending, securitization, leveraging, and housing booms.

Subprime mortgages have been getting a lot of attention in the United States since 2000, when the number of subprime loans being originated and refinanced shot up rapidly. The attention intensified in 2007, when defaults on subprime loans began to skyrocket. Researchers, policymakers, and the public have tried to identify the factors that explained these defaults.

Unfortunately, many of the most popular explanations that have emerged for die subprime crisis are, to a large extent, myths. On close inspection, these explanations are not supported by empirical research.

Myth 1 : Subprime mortgages went only to borrowers with impaired credit

Subprime mortgages went to all kinds of borrowers, not only to those with impaired credit. A loan can be labeled subprime not only because of the characteristics of the borrower it was originated for, but also because of the type of lender that originated it, features of the mortgage product itself, or how it was securitized.

Specifically, if a loan was given to a borrower with a low credit score or a history of delinquency or bankruptcy, lenders would most likely label it subprime. But mortgages could also be labeled subprime if they were originated by a lender specializing in high-cost loans- although not all highcost loans are subprime. Also, unusual types of mortgages generally not available in the prime market, such as "2/28 hybrids," which switch to an adjustable interest rate after only two years of a fixed rate, would be labeled subprime even if they were given to borrowers with credit scores diat were sufficiendy high to qualify for prime mortgage loans.

The process of securitizing a loan could also affect its subprime designation. Many subprime mortgages were securitized and sold on the secondary market. Securitizers rank ordered pools of mortgages from the most to the least risky at the time of securitization, basing the ranking on a combination of several risk factors, such as credit score, loanto-value and debt-to-income ratios, etc. The most risky pools would become a part of a subprime security. AU the loans in that security would be labeled subprime, regardless of the borrowers' credit scores.

The myth that subprime loans went only to those with bad credit arises from overlooking the complexity of the subprime mortgage market and the fact that subprime mortgages are defined in a number of ways- not just by the credit quality of borrowers. One of the myth's byproducts is that examples of borrowers with good credit and subprime loans have been seen as evidence of foul play, generating accusations that such borrowers must have been steered unfairly and sometimes fraudulendy into the subprime market.

Myth 2: Subprime mortgages promoted homeownership

The availability of subprime mortgages in the United States did not facilitate increased homeownership. Between 2000 and 2006, approximately one million borrowers took subprime mortgages to finance the purchase of their first home. These subprime loans did contribute to an increased level of homeownership in the country- at the time of mortgage origination. Unfortunately, many homebuyers with subprime loans defaulted within a couple of years of origination. The number of such defaults outweighs the number of first-time homebuyers with subprime mortgages.

Given that there were more defaults among all (not just first-time) homebuyers with subprime loans dian there were first-time homebuyers with subprime loans, it is impossible to conclude that subprime mortgages promoted homeownership. …