Randall S Kroszner: The challenges facing subprime mortgage
borrowers
Speech by Mr Randall S Kroszner, Member of the Board of Governors of the US Federal
Reserve System, at the Consumer Bankers Association 2007 Fair Lending Conference,
Washington DC, 5 November 2007.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
I am delighted to have been invited to speak to you about the important and pressing
problems in the subprime mortgage market. My remarks today will address those problems,
with particular focus on how they are affecting borrowers. The sharp increases in subprime
mortgage loan delinquencies and foreclosures this year have created personal, economic,
and social distress for many homeowners and communities. I will discuss first the forces that
caused that distress and then turn to the prospects for troubled borrowers. Finally, I will
address the critical question of what can be done to keep the affected families in their homes
and alleviate the other difficulties they and their communities will face.
Background on the subprime mortgage market
Subprime loans are associated with high credit risk because the borrower lacks a strong or
lengthy credit history or has other characteristics that are associated with high probabilities of
default. The expansion of subprime lending since the mid-1990s has been quite substantial,
with the number of subprime mortgage loans now totaling 7-3/4 million, or 14 percent of the
overall mortgage market. Technological advances and financial innovations that reduced the
costs of lending to higher-risk households contributed importantly to the expansion of the
subprime market. In particular, improvements in information processing allowed lenders to
standardize their underwriting techniques and to better manage risks by adjusting the terms
of loans to reflect the expected probability of default. Ongoing growth in the secondary
market for mortgage loans also contributed to the growth of subprime lending by lowering
transactions costs for investors and by spreading risk more broadly, especially through the
process of securitization. That process allows intermediaries to pool large numbers of
mortgages and sell the resulting cash flows to investors, often as components of structured
securities.
Despite the positive aspects of the longer-term expansion of access to mortgage credit, it
came with features that increased risks to households, the financial system, and the broader
economy. Not surprisingly, subprime loans are more likely to default; for the borrower, this
can mean the loss of a home and reduced access to future credit. Such outcomes can be
even more likely if loan products have complex repayment terms that are not fully
understood, or if the borrowers have unrealistic expectations of their future income or house
prices. On the lender side, the originate-to-distribute model can leave lenders with weaker
incentives to maintain strong underwriting standards. In particular, originators who securitize
may inadequately screen potential borrowers unless investors provide oversight and insist on
practices that align originator incentives with the underlying risk. The originate-to-distribute
system is thus not only a potential source of risk to the financial system but also raises
concerns regarding consumer protection.
Sources of the recent problem
With this background in mind, let me turn now to the recent problems in the subprime
mortgage market. As is widely known, delinquency rates on subprime mortgages have
increased sharply over the past year. The distress has been concentrated among the
twothirds of subprime borrowers who have variable-rate mortgages; more than 17 percent of
those mortgages are in serious delinquency, about a tripling of the share since mid-2005.1
Near-prime loans are showing a rise in serious delinquencies as well, although it is much
smaller than for subprime. Serious delinquencies encompass foreclosures, and those are
also up sharply - lenders initiated foreclosure proceedings for an average of 320,000
mortgage loans per quarter in the first half of this year, up from 240,000 loans per quarter
over the preceding two years.2 This increase in foreclosures has been largely associated
with subprime mortgages.
Many factors contributed to the sharp increases in subprime delinquencies and foreclosures,
both separately and in combination. First, the unemployment rate in an area can significantly
undermine the ability of people in that area to repay their mortgages. States in the Midwest
hit hardest by job cuts in the auto industry, such as Michigan and Ohio, are among the states
with the highest rates of new foreclosures.
A second key factor has been the slowing of house prices: One national index, which rose at
close to a double-digit pace from 2000 through 2005, has slowed to show only small gains
for the past several quarters, and some areas are seeing outright price declines. By damping
the growth of home equity, sluggish house-price appreciation makes it harder for
homeowners struggling with payments to obtain better terms through refinancing or to
withdraw accumulated equity to finance their obligations. In addition, borrowers with
mortgages "under water" - that is, the house is worth less than the mortgage balance - may
be tempted to walk away from their loans. That outcome may be particularly likely for those
who purchased properties purely for investment purposes; indeed, the Mortgage Bankers
Association has found that a disproportionate share of serious delinquencies are associated
with non-owner-occupied properties in some of the states that have seen the largest
increases in delinquencies.
A third factor that contributed to the sharp rise in payment problems among subprime
mortgages appears to have been a loosening of underwriting standards for such mortgages
in late 2005 and 2006. Investors, having seen several years in which mortgages showed
extremely strong performance, apparently did not demand sufficient information from sellers
of mortgages and related products during this later period.3 As I already noted, inadequate
monitoring can leave originators with weak incentives to maintain strong underwriting
standards under the originate-to-distribute model.
Many subprime originators, for example, engaged in so-called risk-layering - in which they
made loans to borrowers not only with weak or short credit histories but also with other risk
factors. More than one-third of subprime mortgages originated in the second half of 2005 and
2006, for instance, carried a second lien, up from an average of only about 10 percent over
the preceding three years.4 The greater prevalence of such "piggyback loans" contributed to
higher initial cumulative loan-to-value ratios. In addition, the share of subprime mortgages
with full documentation fell to about 60 percent in late 2005 and 2006 from about 70 percent
1
Seriously delinquent mortgages are more than ninety days in arrears or in foreclosure. Estimates are based
on data from First American LoanPerformance.
2
Foreclosure estimates are based on data from the Mortgage Bankers Association, adjusted to reflect the
limited coverage of the association"s sample.
3
For a more comprehensive treatment of the causes and results of the failure of investors to exercise due
diligence, refer to my recent speech to the Institute of International Bankers, in which I noted that the episode
underscores the importance of the Russian proverb: "Trust but verify" (Randall S. Kroszner, 2007, "Recent
Events in Financial Markets," speech delivered at the Institute of International Bankers Annual Breakfast
Dialogue, October 22).
4
The estimates in this paragraph are based on analysis of loan-level data from LoanPerformance by Federal
Reserve Board staff.
BIS Review 126/2007
over the preceding three years. Another underwriting practice in the subprime mortgage
market that can add to risk is the failure to escrow taxes and insurance, which can result in
payment shock to the borrower if the borrower did not fully anticipate the costs of taxes and
insurances on the property.
These and other shifts in underwriting standards, coupled with slowing house price
appreciation or even depreciation, are the most likely explanation for the pronounced rise we
have seen in defaults occurring within a few months of origination - before most borrowers
would have experienced significant changes in their payment obligations or in their financial
situations.
Finally, another factor that could affect subprime delinquencies is the substantial payment
increase often experienced at the first interest rate reset. For the most common type of
subprime variable-rate loan, the so-called "2/28" loan, this reset occurs after two years,
before which payments are typically based on a fixed below-market rate. In early 2007, the
typical subprime mortgage experiencing a first reset had its rate increase from 7 percent to
91/2 percent, producing an increase of 25 percent to 30 percent in the monthly payment. This
increase translates into an additional monthly debt obligation of $350 per month for the
average subprime variable-rate mortgage.
In the past, many subprime borrowers have avoided such payment increases by refinancing;
for example, about two-thirds of subprime 2/28s originated in 2003 and 2004 were
terminated through a refinancing or home sale by the time of the first scheduled reset.
Prepayments on subprime variable-rate loans originated in late 2005 and 2006, however,
have occurred at a slower pace, likely in part because the combination of sluggish house
price appreciation and high initial cumulative loan-to-value ratios has left some borrowers
with too little equity to qualify for new loans.
Prospects for subprime borrowers
Looking ahead, two considerations suggest that conditions for subprime borrowers have the
potential to get worse before they get better. First, all indications are that housing activity is
continuing to weaken. Incoming data in recent weeks show that sales and new residential
construction have declined further. In such an environment, house prices in the aggregate
are likely to remain sluggish for some time. Second, the bulk of resets is yet to come: On
average, in each quarter from now until the end of next year, monthly payments for more
than 400,000 subprime mortgages are scheduled to undergo their first interest rate reset.
That number is up from roughly 200,000 per quarter during the first half of 2007.
Delinquencies and foreclosures are therefore likely to continue to rise for a number of
quarters.
Many of the borrowers facing resets will still have solid payment records and enough home
equity to refinance. But others will face challenges from not only low levels of home equity
but also from considerably tighter credit conditions. The Federal Reserve's recent surveys of
senior loan officers at banks have showed a significant tightening of standards on subprime
loans. In addition, many lenders that dealt only in subprime loans have gone out of business,
and other large lenders have cancelled some subprime lending programs. The issuance of
new securitized pools of subprime loans has dwindled in the past couple of months, and
judging from the few deals that are being placed, spreads are extremely wide. The supply of
funds for subprime loans is likely to remain low for some time as investors gather information
and reevaluate the risks.
Helping borrowers and mitigating losses
These circumstances call for a high degree of collaboration and innovation to identify
solutions that can keep borrowers confronting foreclosure in their homes. The loss of a home
to foreclosure is distressing to families and communities and can cause significant financial
and social difficulties. We should also pay particular attention to communities that may face
more challenges than others, such as African-American families, who, according to data
collected under the Home Mortgage Disclosure Act, account for a disproportionate share of
higher-price (and thus more likely to be subprime) loans.5
It is imperative that we work together as a financial services community to look for ways to
help borrowers address their mortgage challenges, particularly those who may have fewer
alternatives, such as lower-income families. Toward this end, the Federal Reserve's
Community Affairs Offices have been convening lenders, community leaders, and
government officials around the country over the past two years to help identify strategies to
provide resources to assist borrowers confronting foreclosure. Most recently, the Federal
Reserve Bank of Chicago sponsored symposiums in Chicago, Indianapolis, and Detroit to
discuss factors contributing to increasing foreclosure rates and to highlight innovative
intervention programs. Another meeting will be held in Waukesha, Wisconsin, in December.
In addition, the Federal Reserve and other banking supervisory agencies have issued
statements in recent months urging both lenders and servicers to look for ways to work with
borrowers having difficulty in meeting their mortgage loan obligations.6 These statements
note that prudent workout arrangements that are consistent with safe and sound lending
practices are generally in the long-term interests of both the financial institution and the
borrower. The September statement identifies prudent strategies for loss mitigation for
servicers, including loan modifications, deferral of payments, extension of loan maturities,
capitalization of delinquent amounts, and conversion of adjustable-rate mortgages into
fixedrate mortgages or fully indexed, fully amortizing adjustable-rate mortgages.
Lenders and servicers generally would want to work with borrowers to avoid foreclosure,
which, according to industry estimates, can lead to a loss of as much as 40 percent to 50
percent of the unpaid mortgage balance. Loss mitigation techniques that preserve
homeownership are typically less costly than foreclosure, particularly when applied before
default. Borrowers who have been current in their payments but could default after reset may
be able to work with their lender or servicer to adjust their payments or otherwise change
their loans to make them more manageable.
Comprehensive data about how many loan workouts and modifications have actually
occurred are not available, but some reports suggest that the numbers may be limited thus
far. One possible contributing factor is that many borrowers are not seeking help or advice
from their lenders because they believe that lenders cannot or are not willing to help them.
Industry and consumer advocates who testified at our hearings on the home equity lending
market last year told us that the greatest barrier to working with troubled borrowers is in
simply making contact with them. These witnesses told us that lenders can reach troubled
borrowers through trusted community advocates and that partnerships between community
groups and lenders can reduce the number of homes lost to foreclosure. In addition, the
analysis necessary to identify the best sustainable workout solutions that take into account
the specific circumstances of individual borrowers can require a great deal of time and
resources. Trusted counselors can also help here.
One national nonprofit organization, NeighborWorks America (NeighborWorks), is making
important strides in helping facilitate loan workouts and modifications.7 As a member of the
board of NeighborWorks, I have the privilege of seeing firsthand how this organization has
mobilized its national network of affiliates and partners to respond to the threat of
foreclosures in various communities throughout the country. Through its Center for
Foreclosure Solutions, NeighborWorks has partnered with mortgage and insurance
companies to help train and develop foreclosure counselors, conduct outreach to borrowers
in trouble, and promote research to help inform strategic solutions for families and
communities. A primary tool of the center is a hotline - 1-888-995-HOPE (4673) - that
borrowers in financial distress can contact any time - twenty-four hours a day, seven days a
week - to seek assistance from a mortgage counselor.
So far this year, the hotline has received more than 100,000 calls, with more than half of
those calls received in the third quarter alone. As more subprime ARMs reset over the
course of coming quarters, services aimed at preventing foreclosures will continue to be
strained, and all stakeholders will need to be innovative in identifying strategies to help
preserve sustainable homeownership.
A recent collaborative initiative that may help to alleviate some of the resource challenge is
the Hope Now alliance. This collaboration among counselors, servicers, investors, and other
mortgage market participants aims to increase outreach efforts to contact at-risk borrowers
through a national direct-mail campaign, encouraging them to either call their lender or a
credit counselor. The alliance will work to expand the capacity of an existing national network
to counsel, refer, and connect borrowers to servicers. Participating servicers have agreed to
work toward cross-industry technology solutions to more effectively link servicers and
counselors to better serve the homeowner.
A promising effort started by the states is the new Foreclosure Prevention Working Group.
Consisting of eleven state attorneys general plus the Conference of State Bank Supervisors
and the state bank regulatory agencies, the Working Group has held conversations with
mortgage servicers and will continue to pursue opportunities for preventing foreclosures and
encouraging increased loan modifications.
All these efforts are important, but there is more to be done to deal with the significant
challenges ahead. First, at this point, we are hearing that many modifications are done on a
case-by-case basis. That is understandable given the complexity of the products and the
unique circumstances of each borrower. Given the substantial number of resets from now
through the end of 2008, however, I believe it would behoove the industry to join together
and explore collaborative, creative efforts to develop prudent loan modification programs and
other assistance to help large groups of borrowers systematically.
Second, I believe that modernization of programs administered by the Federal Housing
Administration, which has considerable experience helping low- and moderate-income
households obtain home financing, could also help avoid foreclosures. FHA modernization
could give the agency the flexibility to work with private-sector lenders to expedite the
refinancing of creditworthy subprime borrowers and to design products that improve
affordability through such features as variable maturities or shared appreciation.
Third, we must pursue initiatives to prevent these problems from recurring, and the Federal
Reserve is making strides in this direction. We are engaged in a rigorous review of the
mortgage-related rules under Regulation Z, which implements the Truth in Lending Act
(TILA), and we intend to issue proposals before the end of the year to ban several deceptive
advertising practices and require important consumer disclosures earlier in the mortgage
process to better enable consumers to compare and shop among loan products.
We also plan to issue proposed regulations under the Home Ownership and Equity
Protection Act to address unfair or deceptive mortgage lending practices that would apply to
subprime loans offered by all mortgage lenders. We will address some practices associated
with subprime lending, such as prepayment penalties, failure to offer escrow accounts for
taxes and insurance, stated-income and low-documentation lending, and the failure to give
adequate consideration to a borrower's ability to repay. For example, as I mentioned earlier,
failure to escrow for taxes and insurance can lead to a situation akin to payment shock for
borrowers. It is a common practice for these payments to be escrowed in the prime markets,
and I see no reason that escrows should not be standard practice in the subprime markets
too.
All told, the spirit of innovation is essential to addressing the issue that is before us now as
lenders, investors, regulators, community leaders, and borrowers. As stakeholders and
beneficiaries of the mortgage market, we all share an interest in working together to
implement solutions that maintain a robust, transparent credit environment that promotes
access to responsible mortgage lending.