May 7, 2007

Public Interest Comment on Subprime Mortgage Lending

  • Todd Zywicki

    Senior Fellow, F. A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics
Key materials
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 The Regulation

  • The federal financial regulatory agencies (the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the National Credit Union Administration) have proposed a statement discussing criteria and guidelines that lenders should follow when determining a borrower's ability to repay a loan. 

Our Findings

Evidence shows that subprime lending has expanded homeownership opportunities to millions of borrowers who were previously excluded from mortgage markets.  The higher interest rates and other controversial terms of subprime loans are examples of risk-based pricing, which lenders use to mitigate the increased risk of subprime borrowers.

  • A significant expansion of homeownership rates has coincided with the expansion of subprime lending over the past decade.
  • While subprime borrowers are more likely than prime borrowers to be delinquent or default on their loans, the vast majority of subprime loans are repaid on time.
  • Subprime lenders offer most of their loans to the least risky subprime borrowers.  These borrowers' credit histories are only slightly below a prime rating, and many subprime borrowers can qualify for a prime loan after a year or two of timely repayment on their subprime loans.
  • Since subprime foreclosures began to increase, many lenders have begun to tighten their own lending standards and stopped originating the riskiest types of loans.
  • Restricting predatory lenders' ability to charge interest rates or penalty fees to accurately reflect the risk of certain loans could result in fewer subprime mortgages, and lost homeownership opportunities for many low and moderate income families.  Many subprime borrowers use their home as their primary mode of investment.

By the Numbers

  • From 1965 to 1995, the homeownership rate varied between 63 percent and 66 percent.  Since 1995, the U.S. homeownership rate has risen from around 65 percent to its current level of nearly 69 percent. 
  • Following the adoption of an anti-predatory lending law in North Carolina (which restricted the types of loans that were allowed), subprime mortgage originations dropped 14 percent.

Recommendations

  • The subprime mortgage market is relatively new, and some lenders and borrowers misjudged the risk of loans and originated overly-risky loans-but most borrowers are now better off because of their subprime loans.  The financial regulatory agencies should consider the unintended consequences of possible rationing or tightening of lending standards due to any restrictions on mortgage loans.  They should also consider the cumulative effect of disclosure regulations on the ability of consumers to understand the information in front of them when applying for a loan.