By Karen Petrou
In the wake of the great financial crisis, an axiom of consumer finance is that high-risk borrowers are disproportionately lower-income people. Indeed, the term “subprime” has become a virtual synonym for the lower-income households generally designated with low credit scores and, thus, the subprime sobriquet. However, a growing body of research demonstrates conclusively that subprime borrowers were not the villains of the mortgage debacle at the heart of the 2008 cataclysm: it turns out that prime borrowers behaving in subpar ways defaulted far more often than low-income households trying to become homeowners.
Since 2008, regulators have comforted themselves that the U.S. is immune to renewed mortgage risk because only high-score borrowers are getting mortgages. Time to reconsider credit-underwriting standards that freeze lower-income households out of a critical wealth-accumulating asset: a home of their own.
What the Research Shows
The seeming link between low income and high risk now powers the entire construct of U.S. mortgage credit underwriting. Using conventional FICO scores running from 300 at the bottom to 850 for the presumably credit-risk impregnable, the median credit score for new mortgages in the most recent Federal Reserve Bank of New York data was 770. This is in sharp contrast to the median 715 score in 2000, when homeownership was higher and well before the “subprime” mortgage boom ahead of 2008.
Growing research suggests that these newly-high scores are not only no panacea to renewed risk but likely also dangerously misleading. A 2018 Federal Reserve Bank of Atlanta paper found that the crisis was driven by prime borrowers who led the market in the speculative behavior and mortgage fraud that caused the bust. Counties with house price booms were negatively correlated with subprime-lending increases, with much of the crisis due to investors, not homeowners. 2017 NBER research also found that “prime” investors were the principal cause of crisis-precipitating mortgage defaults, not true subprime borrowers taking out loans for genuine homeownership. This paper found that credit growth between 2001 and 2007 was concentrated in the middle and at the top of the credit-score distribution, while borrowing by those with low credit scores was virtually constant during the boom – rising defaults during the financial crisis were concentrated in the middle of the credit-score distribution.
A massive analysis from the Federal Housing Finance Agency in 2019 seconds these findings. Using troves of data on purchase-money mortgages from 2006 to 2017 and thus going beyond the boom/bust analyses noted above, FHFA found that lending to subprime borrowers wasn’t the problem – crisis risks is due to loan terms that facilitate property and household leverage. Low scores (i.e., below 660) were not the default predictor largely assumed in the absence of an examination also of loan terms, conditions, and borrower/property leverage.
Finally, a brand-new study from the Federal Reserve Bank of New York concludes that the mortgage crisis beginning in 2007 was not due to subprime borrowing, but instead lay in boom-market patterns largely powered by prime borrowers. There is a negative correlation between house-price and subprime-lending increases before the crisis, likely due to the fact that higher-risk borrowers were increasingly priced out of boom markets. The paper recognizes that this negative correlation still makes it possible that subprime loans were at the heart of the crisis because they may have been more likely to be fraudulent due to speculation or poor appraisals. However, speculators are by definition not true subprime purchase or even refi borrowers, and inflated appraisals in boom counties were found to be less likely for subprime borrowers.
Now We Know, What to Do
The insights in many of these studies are not new to students of safety-and-soundness regulation, but they should be epiphanal to the safety-and-soundness regulators who ignored early warnings along these lines to craft the post-crisis mortgage framework’s punitive standards for subprime borrowers.
Going back to 2010, the Joint Forum of global bank, securities, and insurance regulators recognized that equity extraction – i.e., using home equity to leverage more borrowing, high loan-to value ratios, and investor – not residential – properties were at least as risky as lending to borrowers with high debt-to-income ratios or other, more traditional indicia of mortgage risk. More recent studies finds that lenders with little capital at risk arbitrage credit-score criteria by granting higher-risk loans to seemingly prime borrowers.
Seemingly tough post-crisis capital standards for banks ignored these lessons, treating all mortgages as essentially the same risk except for those with the highest loan-to-value (LTV) ratios. A punitive capital charge for mortgage servicing combined with tough stress testing standards and heightened liability drove banks out of the mortgage business in favor of underwriting loans for sale to Fannie Mae and Freddie Mac. There, as noted, high score requirements now exclude many borrowers even as the GSEs’ portfolios of loans with debt-to-income ratios over fifty percent climb higher and higher.
Another reason for the mortgage market’s migration from lower-income borrowers is the post-crisis “qualified mortgage” criterion based on DTI. The rationale here is that borrowers with pre-existing debt are the least likely to repay a mortgage loan and, holding all other factors true, this is intuitively and historically correct. However, all of the rules do not hold all other things equal – as these studies show, they allow borrowers with risk indicators far more worrisome than higher DTIs to get loans for speculative – not sustainable – homeownership-purposes. These are far afield from the low-income Detroit homeowners who stubbornly tried to repay their loans until the crisis overtook them – ironically a crisis borne not of their inability to repay, but instead that of wealthier suburbanites and boom-town buyers who couldn’t cover their bets.
Given that post-crisis underwriting now affirmatively excludes these lower-income borrowers, the risks of renewed speculation are even greater now because mortgage credit risk is increasingly concentrated in high-score borrowers taking out high-risk loans. The billions bet on rental homes backed by highly-leveraged companies adds another facet to this troublesome structure, one now facing acute risk if the general business-cycle slowdown is accelerated by COVID-19 economic shocks.