## 1. Homeownership Rate

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---

### Introduction
- After a number of warning signs, the U.S. “subprime mortgage crisis” became a headline issue in February 2007.
- Despite bankruptcy of numerous mortgage companies, historically high delinquencies and foreclosures, and a significant tightening in subprime lending standards, the impact thus far on core U.S. financial institutions has been limited.
- Structured credit hedge funds have suffered large losses, but mortgage securitization appears to have helped disperse the impact throughout the financial system.
- The credit cycle is largely playing out in the securities and derivatives markets, rather than on bank balance sheets.
- New origination and funding technology appear to have made the financial system more stable at the expense of undermining the effectiveness of consumer protection regulation.

### Origins and history of the subprime mortgage market
- Definitions and assessment criteria:
  - Subprime mortgages: residential loans that do not conform to the criteria for “prime” mortgages and have a lower expected probability of full repayment.
  - Assessment criteria include borrower’s credit record and score, debt service-to-income (DTI) ratio, and mortgage loan-to-value (LTV) ratio.
  - Borrowers with low credit scores, DTIs above 55 percent, and/or LTVs over 85 percent are likely to be considered subprime.
  - “Alt-A” loans occupy a gray area between prime and subprime; originated mainly for borrowers who met prime criteria but did not provide full income documentation.
- Legal, tax, technological, and market-structure developments:
  - Interest rate caps imposed by states were preempted by federal legislation in 1980; adjustable-rate mortgages allowed from 1982.
  - The Tax Reform Act of 1986 left residential mortgages as the only consumer loans with tax-deductible interest, encouraging home equity withdrawal.
  - Automated underwriting reduced origination costs (estimates include "up to three percent of total loan values" and "$916 on each loan"), though model resilience in a severe consumer-led recession is questioned.
  - Securitization dispersed risk, provided investors with highly-rated securities with enhanced yield, and opened origination to non-depository specialty finance companies.
- Social outcomes and homeownership expansion:
  - Subprime lending facilitated expansion of home ownership: cited "nearly 9 million new homeowners are now able to live in their own homes..." (Gramlich, 2004).
  - U.S. Census Bureau data: national homeownership rate rose from 64.7 percent in 1995 to 68.8 percent in 2006.
  - Rise greater among African American households (42.7 to 47.9 percent) and Hispanic households (42.1 to 49.7 percent).
  - Federal Reserve’s Survey of Consumer Finances: rise in homeownership from 1995 to 2004 was six percent in lower-income census tracts, versus four percent in higher-income tracts.
- Shift away from FHA:
  - Subprime loans displaced FHA-guaranteed lending because FHA’s product mix was less aggressive, less flexible, and had low lending limits.
  - Originators complained that FHA fees did not adequately compensate for higher processing costs.

### Mechanics of mortgage securitization (Box 1)
- Subprime mortgages are predominantly securitized as mortgage-backed securities (MBS).
- Credit-enhancement mechanisms:
  - Subordination: losses applied to junior tranches before senior tranches; most senior tranches are rated AAA and trade at lower spreads.
  - Overcollateralization: excess of outstanding mortgage loans over par value of securities used to cover shortfalls.
  - Excess spread: preset amount of interest set aside from collateral servicing each month to enhance initial overcollateralization; a “residual tranche” collects unused excess spread and overcollateralization.
- Typical tranche composition:
  - AAA-rated “Class A” tranches comprise about 80 percent of a typical transaction.
  - Remaining 20 percent typically: 10 percent AA, 5 percent A, and 5 percent BBB+ and below.
  - “Class M” mezzanine tranches are typically resecuritized into collateralized debt obligations (CDOs); below-mezzanine tranches usually retained by originator or sold to hedge funds and proprietary desks.
- CDOs and market demand:
  - J.P. Morgan Securities: about $244 million of ABS-backed CDOs were issued in the U.S. in 2006, about $98 billion of which were “mezzanine” ABS CDOs (backed mainly by mezzanine MBS tranches).
  - A reduced “CDO bid” for mezzanine tranches could dramatically shrink subprime mortgage financing because of structural linkages between saleability of senior and junior tranches and leveraged effects in the CDO market.
- Excess-spread specifics:
  - Excess spread is the difference between net interest rate on underlying loans and weighted-average coupon on securities.
  - Excess spread used to over-collateralize senior tranches, typically up to a certain point (e.g., three percent of notional) over a certain period (e.g., three years); after target over-collateralization is attained, some excess spread can be released to the residual tranche.

### Rapid recent expansion and market composition (2006 originations)
- 2006 originations composition:
  - 36 percent conforming loans.
  - 15 percent prime “jumbo” loans.
  - 3 percent loans guaranteed by the FHA and the Department of Veterans Affairs (VA).
  - Remainder nonprime: Alt-A 25 percent and subprime 21 percent.
- Drivers of expansion:
  - Conforming single-family loan limits and strict documentation combined with rising house prices pushed more loans outside conforming criteria.
  - GSEs contracted mortgage purchase operations due to accounting and governance issues.
  - Innovative securitization techniques provided private-label originators with lower funding costs.
- Historical precedent:
  - Subprime market experienced a “crisis” in 1998-99 when delinquencies exceeded expectations, investor appetite fell, and major subprime lenders went bankrupt.

### Declining mortgage holdings of depository institutions
- Depository institutions originate half of all mortgages but hold only 30 percent of outstanding loans.
- End-2006 distribution of outstanding mortgages:
  - 38 percent held by GSE securitization pools (plus 3 percent held directly by the GSEs).
  - 18 percent by non-GSE (“private label”) securitization pools.
  - 5 percent by finance companies.
  - Most of the remainder by real estate investment trusts (REITS) and households.

### What prompted the subprime “crisis?”
- Contributing factors:
  - Rapid lending growth accompanied by more highly leveraged lending and rapidly rising house prices.
  - Housing affordability dropped; many borrowers used risky “affordability products.”
  - Reports of borrowers lying about financial resources; speculative borrowers obtained loans based on expected collateral appreciation.
  - Average subprime borrower credit scores rose while LTVs and DTIs also rose, driven in part by increased use of second-lien loans.
- Incentive and monitoring breakdowns:
  - Strong investor appetite for higher-yielding securities in 2005–06 likely contributed to looser underwriting standards.
  - Fee-driven remuneration at each stage and dispersion of credit risk weakened monitoring incentives; intermediaries were remunerated primarily by generating loan volume rather than loan quality.
- Triggering mechanism:
  - Rapid deterioration of 2006 vintage loans resulted largely from a slowing of house price appreciation—distressed borrowers could no longer sell or refinance and defaulted.

### Box 2 — ARMs, hybrids, IOs, Neg-Ams, and teasers: product mechanics and performance
- Product mechanics and features:
  - Most ARMs are hybrid products; about two-thirds of recent ARM originations were “2/28” hybrids (two-year FRMs converting to 28-year ARMs).
  - Initial fixed “teaser” rates can produce “reset shock”; various caps often protect borrowers from rapid payment increases.
  - Interest-only (IO) mortgages: interest-only payments for initial years (usually two or three for ARMs; up to ten for FRMs).
  - Negative amortization (Neg-Am) mortgages: payments do not cover interest; negative amortization typically capped at 15 to 25 percent of the original loan amount; loan converts to full-interest loan when cap hit; loans recast every five years.
  - Option ARMs: borrowers choose monthly payment options including IO and Neg-Am; options typically remain until five years into the mortgage or until outstanding balance reaches 110 percent of original principal.
  - Option ARM originations surged since 2003 from around 10 percent of Alt-A origination to about 40 percent (Barclays Capital, 2006).
- Performance observations and recent deterioration:
  - IO and Neg-Am loans comprise the bulk of subprime and Alt-A ARM originations.
  - Delinquencies and defaults on subprime mortgages originated in 2006 have soared; ARMs are particularly distress-prone; FRMs have generally fared better.
  - Early payment defaults (misses of one or two of the first three monthly payments) have risen rapidly for recent vintages.
  - Fraud accelerated deterioration and contributed to originator failures in 2006–07 as securitizers exercised “put-back” options.
  - Freddie Mac: ARMs comprise about 90 percent of recent subprime home-purchase loan originations, most incorporating affordability features.
  - Worst-performing loans displayed risk “layering”: high LTV loans to high DTI borrowers with little income verification.

### Losses, timing, and market impact (Box 2 estimates)
- Foreclosure and resolution timelines:
  - Servicer considers a payment delinquent when 15 days late; loan considered “non-recoverable” after 90 days.
  - Voluntary title transfer (deed-in-lieu or short sale) average resolution: about 12 months.
  - Foreclosure average resolution: about 18 months.
- Estimated mark-to-market loss scenarios on MBS-backed CDOs:
  - Assuming flat house prices, $18-$25 billion of mark-to-market losses may accrue on about $350 billion of outstanding MBS-backed CDOs.
  - Assuming house prices fall 5 percent, mark-to-market losses are estimated to rise to approximately $60 billion.
- Broader mortgage loss estimates:
  - Citigroup (2007) estimated undiscounted losses on all mortgages amounting to about $275 billion, $175 billion of which will be on securitized mortgages.
- Hedge funds and investor impact:
  - Losses have crystallized in hedge funds specializing in lower-rated subprime ABS and CDOs; investor withdrawals and margin calls have forced liquidations and realized losses.

### Household impact and refinancing constraints
- Cagan (2007) estimates for 2004–06 ARM originations facing payment shocks:
  - 59 percent will see payment increases of 25 percent or more in 2007 and beyond.
  - 19 percent of loans will see payments increase by 50 percent or more.
  - About 13 percent, or 1.1 million, of these ARMs could foreclose as a result of payment reset during the next seven years, assuming flat house price appreciation.
- For comparison: Mortgage Bankers Association estimated about 800,000 mortgages foreclosed in 2006.
- Refinancing constraints:
  - Subprime borrowers with complete payment histories for the first two or three years may qualify as prime when refinancing.
  - More marginal borrowers with blemished histories will find refinancing difficult in 2007–08 as lenders tighten and house prices fall.
- Prepayment penalties:
  - Typical penalties effective for up to three years after origination and amounts up to six months of interest on 80 percent of the remaining balance.
  - Proportion of subprime mortgages with prepayment penalties peaked at about 80 percent of originations in 2000-02, but declined to about 60 percent after regulatory changes in 2002.
  - Less than two percent of prime loans contain prepayment penalty provisions.

### Originate-to-distribute model: incentives, risk dispersion, and consumer protection
- Incentive and risk-dispersion features:
  - Few lenders retain mortgages they originate, diminishing incentives for diligent underwriting and monitoring.
  - Put-back clauses and recourse provide some alignment but are constrained by short assessment periods and thin originator capitalization.
  - Due diligence at securitization and investor levels can be weakened by risk dispersion and reliance on credit rating agencies.
- Systemic resilience and loss-bearing:
  - Dispersion of credit risk has increased resilience of the U.S. financial system by shifting losses away from core depository institutions to the periphery: thinly-capitalized specialty finance companies, lower-rated ABS and CDO tranches, and some hedge funds; some foreign investors likely bear a proportion of losses.
- Legal and regulatory consumer-protection weaknesses:
  - Borrowers have limited recourse when originators are bankrupt; pursuing redress across securitization conduits is legally complex and costly.
  - MBS investors are “holders in due course” and not responsible for fraudulent or illegal origination practices.
  - Existing federal protections (Truth in Lending Act (1968), HOEPA (1994)) are limited; HOEPA applies only when APR exceeds 8 percent over comparable maturity Treasury yield, excluding many recent subprime originations.
  - Federal banking regulators tightened guidance on nontraditional mortgages and hybrid ARM lending, but fragmented U.S. regulation makes enforcement uneven.

### Policy responses: palliatives and reforms
- Palliatives (servicing and borrower relief):
  - State bodies, GSEs, national groups, and banks offer debt counseling and subsidized refinancing, but programs are of insufficient scale to materially affect projected foreclosures.
  - Regulators encourage servicers to exercise restraint in foreclosing; servicers can offer loan modifications (rate, term, principal), forbearance, or pursue short sales.
  - Constraints on servicer flexibility:
    - Servicer remuneration and fee-based models discourage costly workouts, especially for smaller loans.
    - Securitization documents often limit modifications to 5-10 percent of original value of loans outstanding and require modifications be “in the best interest of investors.”
    - Accounting rules can force substantially modified pools back onto originators’ balance sheets.
    - Loan modifications could create conflicts among ABS tranches if expected cash flows change differentially.
- Future reforms (liability, regulation, FHA changes):
  - Liability proposals:
    - Capped liability of the mortgage assignee (as in five U.S. states) could incentivize securitizers to screen loan quality while avoiding complete market withdrawal; uncapped liability risks collapse of subprime origination and securitization.
    - Making investors liable for predatory or fraudulent loans would raise monitoring obligations and risk premia, and could reduce foreign investor demand for ABS—potentially impairing U.S. external financing.
  - Market-led tightening already evident:
    - Subprime standards tightened from investor, rating agency, and regulatory scrutiny; risk-layering features in securitized mortgages have declined.
    - Fannie Mae and Freddie Mac will buy only subprime securities whose loans adhere to new Federal regulator guidance on non-traditional and hybrid mortgages and have reduced purchases of low- and no-documentation loans; the two GSEs buy about 25 to 30 percent of MBS AAA-rated tranches.
    - Rating agencies are increasing overcollateralization requirements for subprime ABS and refining models to penalize risk-layering.
  - Federal Reserve reviewing regulations on loan disclosure and outlawed practices; consistent enforcement will be difficult given multiple federal and state authorities.
  - Proposed FHA reforms:
    - Expand FHA-guarantee eligibility by increasing maximum mortgage sizes to local median home prices, simplify down-payment rules (including minimal or zero down-payments for qualified applicants), allow FHA to price guarantees to credit risk, and permit more innovative loan products (e.g., 40-year term).
    - Risks include guaranteeing speculative loans and potential taxpayer exposure if guarantees extend to zero down-payment or distressed-refinance subprime loans.

### Policy trade-offs and concluding assessment
- Benefits of innovation:
  - Lower cost of risky mortgages, expanded homeownership (especially among minority groups), and dispersion of default risk away from core depository institutions.
- Costs and vulnerabilities:
  - Viability of the riskiest mortgages dependent on continued house price appreciation.
  - Relaxed lending standards and misaligned incentives in a fee-driven originate-to-securitize chain.
  - Slower reaction of rating agencies to deteriorating performance.
- Policy challenge:
  - Balance greater consumer protection against preserving the viability of the securitization model that disperses higher-risk mortgage losses away from the banking system.
  - Ensure viable subprime borrowers retain reasonable refinancing options when facing reset payment shocks, while preventing recurrence of predatory lending excesses in a regulatory and legal framework currently ill-suited to the originate-to-securitize model.

*Source: _wp07188 - 1. Homeownership Rate (excerpt) and Box 2 content.*

### 1. Homeownership Rate...................................................................................................

### 1. Homeownership Rate

### Introduction
- After a number of warning signs, the U.S. “subprime mortgage crisis” became a headline issue in February 2007.
- Despite bankruptcy of numerous mortgage companies, historically high delinquencies and foreclosures, and a significant tightening in subprime lending standards, the impact thus far on core U.S. financial institutions has been limited.
- Structured credit hedge funds have suffered large losses, but mortgage securitization appears to have helped disperse the impact throughout the financial system.
- The credit cycle is largely playing out in the securities and derivatives markets, rather than on bank balance sheets.
- The paper reviews the history and structure of the subprime market and suggests that new origination and funding technology appear to have made the financial system more stable at the expense of undermining the effectiveness of consumer protection regulation.

### Origins and History of the Subprime Mortgage Market
- Definition and criteria:
  - Subprime mortgages are residential loans that do not conform to the criteria for “prime” mortgages and have a lower expected probability of full repayment.
  - Assessment criteria include borrower’s credit record and score, debt service-to-income (DTI) ratio, and mortgage loan-to-value (LTV) ratio.
  - Borrowers with low credit scores, DTIs above 55 percent, and/or LTVs over 85 percent are likely to be considered subprime.
  - “Alt-A” loans fall into a gray area between prime and subprime mortgages; began as a more flexible alternative to prime loans, mainly for borrowers who met all prime criteria but did not provide full income documentation.
- Legal and tax developments that facilitated market growth:
  - Interest rate caps imposed by states were preempted by federal legislation in 1980.
  - Lenders were allowed to offer adjustable-rate mortgages from 1982.
  - The Tax Reform Act of 1986 left residential mortgages as the only consumer loans on which the interest was tax deductible, making home equity withdrawal a preferred means of financing.
- Technological and market structure changes:
  - Automated underwriting reduced origination costs; estimated savings cited: "up to three percent of total loan values" (LaCour-Little (2000)) and "$916 on each loan" (Davis (2001)), though model resilience in a serious consumer-led recession is questioned (Bies, 2003).
  - Securitization dispersed risk, provided investors with highly-rated securities with enhanced yield, and opened origination to non-depository specialty finance companies.
- Social outcomes:
  - Subprime lending developed as a specialist loan class in the mid-90s and facilitated a substantial expansion of home ownership.
  - Quoted: "nearly 9 million new homeowners are now able to live in their own homes..." (Gramlich, 2004).
  - U.S. Census Bureau data: national homeownership rate rose from 64.7 percent in 1995 to 68.8 percent in 2006; rise greater among African American households (42.7 to 47.9 percent) and Hispanic households (42.1 to 49.7 percent).
  - Federal Reserve’s Survey of Consumer Finances: rise in homeownership from 1995 to 2004 was six percent in lower-income census tracts, versus four percent in higher-income tracts.
- Shift away from FHA:
  - Loans for subprime borrowers were once predominantly guaranteed by the Federal Housing Association (FHA).
  - Subprime loans have displaced FHA-guaranteed lending due to the FHA’s less aggressive product mix, lack of flexibility, and low lending limits.
  - Mortgage originators complain that fees on FHA-guaranteed mortgages do not adequately compensate for higher processing costs.

### Mechanics of Mortgage Securitization (Box 1)
- Subprime mortgages are predominantly securitized as mortgage-backed securities (MBS).
- Credit enhancement mechanisms:
  - Subordination: losses applied to junior tranches before senior tranches; most senior tranches are rated AAA and trade at lower spreads.
  - Overcollateralization: excess of outstanding mortgage loans over par value of securities used to cover shortfalls.
  - Excess spread: preset amount of interest set aside from collateral servicing each month to enhance initial overcollateralization; a “residual tranche” collects unused excess spread and overcollateralization.
- Typical tranche composition:
  - AAA-rated “Class A” tranches comprise about 80 percent of a typical transaction.
  - Remaining 20 percent: typically 10 percent AA, 5 percent A, and 5 percent BBB+ and below.
  - “Class M” mezzanine tranches lack broad natural end investors and are typically resecuritized into collateralized debt obligations (CDOs).
  - Below-mezzanine tranches usually retained by originator or sold to hedge funds and investment bank proprietary desks.
- CDOs and market demand:
  - CDOs are a key investor constituency for mezzanine tranches due to yield pick-up.
  - J.P. Morgan Securities: about $244 million of ABS-backed CDOs were issued in the U.S. in 2006, about $98 billion of which were “mezzanine” ABS CDOs (backed mainly by mezzanine MBS tranches).
  - Speculation exists that a reduction in the “CDO bid” for mezzanine tranches could dramatically shrink subprime mortgage financing due to structural linkage between saleability of senior and junior tranches and leveraged effects in the CDO market.
- Excess spread specifics:
  - Excess spread characterized as difference between net interest rate on underlying loans and weighted-average coupon on securities.
  - Excess spread used to over-collateralize senior tranches, typically up to a certain point (e.g., three percent of notional) over a certain period (e.g., three years); after target over-collateralization is attained, some excess spread can be released to the residual tranche.

### The Rapid Recent Expansion of Subprime Lending
- Market composition by 2006 originations:
  - Only 36 percent of 2006 originations were conforming loans.
  - 15 percent were prime “jumbo” loans.
  - 3 percent comprised loans guaranteed by the FHA and the Department of Veterans Affairs (VA).
  - Remainder comprised nonprime loans—Alt-A (25 percent) and subprime (21 percent).
- Drivers of expansion:
  - Conforming single-family loans capped at $417,000 with strict DTI, LTV, and income documentation requirements—rising house prices stretched affordability and pushed more loans outside conforming criteria.
  - Accounting and governance issues caused GSEs to contract mortgage purchase operations.
  - Innovative securitization techniques provided private-label originators with lower costs of funding.
- Historical precedent:
  - Despite advances in credit scoring, the subprime market experienced a “crisis” in 1998-99 when delinquencies were higher than anticipated and investor appetite fell, leading to bankruptcy of major subprime lenders.

### Declining Mortgage Holdings of Depository Institutions
- Depository institutions still originate half of all mortgages, but hold only 30 percent of outstanding loans.
- End-2006 distribution of outstanding mortgages:
  - 38 percent held by GSE securitization pools (plus 3 percent held directly by the GSEs).
  - 18 percent by non-GSE (“private label”) securitization pools.
  - 5 percent by finance companies.
  - Most of the remainder by real estate investment trusts (REITS) and households.

### What Prompted the Subprime “Crisis?”
- Contributing factors:
  - Rapid lending growth accompanied by more highly leveraged lending and rapidly rising house prices.
  - Housing affordability dropped; a significant proportion of borrowers were financially overstretching via risky “affordability products.”
  - Reports of borrowers lying about financial resources to obtain loans; speculative borrowers obtained loans based on expected collateral appreciation rather than repayment capacity.
  - Average subprime borrower credit scores rose, but LTVs and DTIs also rose, especially due to increased use of second-lien loans, which need not be declared to the primary mortgage lender.
- Incentive and monitoring breakdowns:
  - Strong investor appetite for higher-yielding securities in 2005–06 likely contributed to looser underwriting standards.
  - Fee-driven remuneration at each stage of securitization and dispersion of credit risk weakened monitoring incentives; intermediaries were remunerated primarily by generating loan volume rather than loan quality.
- Triggering mechanism:
  - Rapid deterioration of 2006 vintage loans resulted largely from a slowing of house price appreciation.
  - While prices were rising, distressed borrowers could sell and prepay mortgages; as interest rates rose and house prices flattened or turned negative in some regions, stretched borrowers lacked equity to refinance or prepay and defaulted.

*Source: _wp07188 - 1. Homeownership Rate (excerpt).*

### Box 2. Brothers in ARMs: Hybrids, Options, IOs, Neg-Ams, and Teasers

### Box 2. Brothers in ARMs: Hybrids, Options, IOs, Neg-Ams, and Teasers

### Product mechanics and features
- Most ARMs are hybrid products combining floating and fixed rates; about two-thirds of recent ARM originations were “2/28” hybrids, which are effectively two-year FRMs that convert to 28-year ARMs at the end of the second year.
- The initial fixed rate is often a below-market (“teaser”) rate, producing potential “reset shock” when the adjustable-rate period starts; various caps often protect borrowers from rapid and sharp increases in payments.
- Interest-only (IO) mortgages: payments cover just interest accruals in the first years (usually two or three in the case of ARMs and up to ten for FRMs).
- Negative amortization (Neg-Am) mortgages: payments do not cover interest accruals; accumulated negative amortization is typically subject to a 15 to 25 percent cap relative to the original loan amount; when the cap is hit the loan converts to a full-interest loan. At the end of every five years the loan is recast and payments are recomputed on the new higher loan balance.
- Option ARMs: borrowers choose from a variety of payment options each month, including IO and Neg-Am options. Typically:
  - Options remain open until five years into the mortgage (the “recast date”) or until the outstanding balance reaches 110 percent of the original principal.
  - Interest often accrues at a deeply discounted interest rate until the recast date, after which full principal and interest payments start.
- Option ARM originations surged since 2003, from around 10 percent of Alt-A origination to about 40 percent more recently (Barclays Capital, 2006).

### Performance observations and recent deterioration
- Interest-only and negative amortization loans comprise the bulk of subprime and Alt-A ARM origination.
- Delinquencies and defaults on subprime mortgages originated in 2006 have soared despite a benign economic backdrop; ARMs have been particularly distress-prone, while FRMs have generally fared better.
- Early payment defaults (misses of one or two of the first three monthly payments) have risen rapidly for recent vintages.
- Fraud appears to have accelerated deterioration, contributing to originator failures in 2006–07 as securitizers exercised “put-back” options.
- According to Freddie Mac, ARMs comprise about 90 percent of recent subprime home-purchase loan originations, most of which incorporate affordability features.
- Worst-performing loans exhibited risk “layering”: high LTV loans to high DTI borrowers with little income verification.

### Losses, timing, and market impact
- Not all delinquent loans default; foreclosure processes and related timelines:
  - Servicer considers a payment delinquent when 15 days late; loan considered “non-recoverable” after 90 days, at which point workout or liquidation proceedings begin.
  - Voluntary title transfer (“deed-in-lieu” or pre-foreclosure “short sale”) takes an average of about 12 months to resolve; foreclosure takes about 18 months.
- Estimated mark-to-market loss scenarios on MBS-backed CDOs:
  - Assuming flat house prices, $18-$25 billion of mark-to-market losses may accrue on about $350 billion of outstanding MBS-backed CDOs.
  - Assuming house prices fall 5 percent, mark-to-market losses are estimated to rise to approximately $60 billion.
- Broader mortgage loss estimates mentioned:
  - Citigroup (2007) estimated undiscounted losses on all mortgages amounting to about $275 billion, $175 billion of which will be on securitized mortgages.
- Losses have begun to crystallize in hedge funds specializing in lower-rated subprime ABS and CDOs; investor withdrawals and margin calls have forced liquidations and realized losses.

### Household impact and refinancing constraints
- Cagan (2007) estimates for 2004–06 ARM originations facing payment shocks:
  - 59 percent will see payment increases of 25 percent or more in 2007 and beyond.
  - 19 percent of loans will see payments increase by 50 percent or more.
  - About 13 percent, or 1.1 million, of these ARMs could foreclose as a result of payment reset during the next seven years, assuming flat house price appreciation.
- For comparison: the Mortgage Bankers Association estimated about 800,000 mortgages foreclosed in 2006.
- Refinancing as a mitigation strategy is now harder:
  - Subprime borrowers who maintain a complete payment history for the first two or three years may qualify as prime when refinancing.
  - More marginal borrowers (low credit scores and high LTV/DTIs) with blemished payment histories will find refinancing difficult in 2007–08 as lenders tighten standards and house prices fall.
- Prepayment penalties hamper borrowers’ ability to refinance; typical prepayment penalty features:
  - Effective for up to three years after origination and amounts up to six months of interest on 80 percent of the remaining balance.
  - Proportion of subprime mortgages with prepayment penalties peaked at about 80 percent of originations in 2000-02, but declined to about 60 percent after regulatory changes in 2002.
  - Less than two percent of prime loans contain prepayment penalty provisions.

### Originate-to-distribute model: incentives, risk dispersion, and consumer protection
- Originate-to-distribute model driven by fee generation, risk dispersion, and compartmentalization; creates potential incentive conflicts:
  - Few lenders retain mortgages they originate, diminishing incentives for diligent underwriting and monitoring.
  - Put-back clauses and recourse help align incentives but are constrained by short assessment periods and thin originator capitalization.
  - Due diligence at securitization and investor levels can be weakened by risk dispersion and reliance on credit rating agencies.
- The dispersion of credit risk has increased resilience of the U.S. financial system by shifting losses away from core depository institutions to:
  - The origination network’s periphery of thinly-capitalized specialty finance companies, lower-rated ABS and CDO tranches, and some hedge funds.
  - Some foreign investors likely bear a proportion of losses.
- Legal and regulatory consumer protection weaknesses in a securitized market:
  - Borrowers have limited recourse when originators are bankrupt and pursuing redress across securitization conduits is legally complex and costly.
  - MBS investors are “holders in due course” and not responsible for fraudulent or illegal origination practices.
  - Existing federal protections (Truth in Lending Act (1968), HOEPA (1994)) are limited in scope for current subprime practices; HOEPA rules apply only when APR exceeds 8 percent over comparable maturity Treasury yield, thus failing to cover many recent subprime originations conducted at lower rates.
- Federal banking regulators have tightened guidance on nontraditional mortgages and hybrid ARM lending, but fragmented U.S. financial regulation means enforcement and observance are uneven across federal and state regulators.

### Policy responses: palliatives and reforms
- Palliatives (servicing and borrower relief):
  - State bodies, GSEs, national groups, and banks offer debt counseling and subsidized refinancing for distressed subprime borrowers, but programs are of insufficient scale to materially affect the projected number of foreclosures.
  - Regulators encourage servicers to exercise restraint in foreclosing; servicers can offer loan modifications (rate, term, principal), forbearance, or pursue short sales to minimize losses.
  - Constraints on servicer flexibility:
    - Servicer remuneration and fee-based models discourage costly workout efforts, especially for smaller loans.
    - Securitization documents often limit modifications to 5-10 percent of the original value of loans outstanding and require that modifications be “in the best interest of investors” without specifying investor classes.
    - Accounting rules can force substantially modified pools back onto originators’ balance sheets.
  - Loan modifications could create conflicts among ABS tranches if expected cash flows change differentially.
- Future reforms (liability, regulation, and FHA changes):
  - Proposals to shift liability for predatory lending to investment banks and rating agencies reflect frustration but raise trade-offs:
    - Capped liability of the mortgage assignee (as in five U.S. states) could incentivize securitizers to screen loan quality while avoiding complete market withdrawal; uncapped liability risks collapse of subprime origination and securitization.
    - Making investors liable for predatory or fraudulent loans would place monitoring obligations on investors lacking origination information, substantially raising risk premia and reducing foreign investor demand for ABS—potentially impairing U.S. external financing.
  - Market-led tightening already evident:
    - Subprime standards have tightened from investor, rating agency, and regulatory scrutiny; risk-layering features in securitized mortgages have declined.
    - Fannie Mae and Freddie Mac will buy only subprime securities whose loans adhere to new Federal regulator guidance on non-traditional and hybrid mortgages and have reduced purchases of low- and no-documentation loans; the two GSEs buy about 25 to 30 percent of MBS AAA-rated tranches.
    - Rating agencies are increasing overcollateralization requirements for subprime ABS and refining models to penalize risk-layering.
  - Federal Reserve is reviewing regulations on loan disclosure and outlawed practices; consistent enforcement will be difficult given multiple federal and state authorities.
  - Proposed FHA reforms aim to expand FHA-guarantee eligibility by increasing maximum mortgage sizes to local median home prices, simplifying down-payment rules (including minimal or zero down-payments for qualified applicants), allowing FHA to price guarantees to credit risk, and permitting more innovative loan products (e.g., 40-year term). Risks include guaranteeing speculative loans and potential taxpayer exposure if guarantees extend to zero down-payment or distressed-refinance subprime loans.

### Policy trade-off and concluding assessment
- The subprime episode highlights costs and benefits of financial innovation:
  - Benefits: lower cost of risky mortgages, expanded homeownership (especially among minority groups), and dispersion of default risk away from core depository institutions.
  - Costs: viability of riskiest mortgages dependent on continued house price appreciation; relaxed lending standards and misaligned incentives in a fee-driven origination-to-securitization chain; slower reaction of rating agencies to deteriorating performance.
- With lending standards tightened and rating models strengthened, the policy challenge is to:
  - Balance greater consumer protection against preserving the viability of the securitization model that disperses higher-risk mortgage losses away from the banking system.
  - Ensure viable subprime borrowers retain reasonable refinancing options when facing reset payment shocks, while preventing recurrence of predatory lending excesses in a regulatory and legal framework currently ill-suited to the originate-to-securitize model.

*Source: IMF staff compilation from the supplied content unit.*

### References

### References

### Bibliographic entries (alphabetical order as in source)
- Apgar, William C., and Allegra Calder, 2005, “The Dual Mortgage Market: The Persistence of Discrimination in Mortgage Lending,” in Briggs, Xavier de Souza, 2005, The Geography of Opportunity: Race and Housing Choice in Metropolitan America, Brookings Institution Press.
- Barclays Capital, 2006, “The ‘Neg Am-ing’ of America?” Barclays Capital US Securitization Research, September 14.
- Bernanke, B.S., 2007, ‘The Subprime Mortgage Market,” Remarks at the Federal Reserve Bank of Chicago, May 17.
- Bies, Susan Schmidt, 2003, “Managing Business Risks,” Speech before the Oregon Bankers Association, Independent Community Banks of Oregon, and Idaho Bankers Association; Sunriver, Oregon, June 16.
- Cagan, Christopher L., 2007, “Mortgage Payment Reset: The Issue and Impact,” First American CoreLogic, March 19.
- Chari, V.V., and Ravi Jagannathan, 1989, “Adverse selection in a model of real estate lending,” Journal of Finance, Vol. 44, 499-508.
- Chomsisengphet, Souphala, and Anthony Pennington-Cross, 2006, “The Evolution of the Subprime Mortgage Market,” Federal Reserve Bank of St. Louis Review, January/February, 31-56.
- Citigroup, 2007, “Bond Market Roundup: Strategy – MBS and Real Estate ABS,” Citigroup United States Fixed Income Strategy & Analysis, March 9.
- Credit Suisse, 2006, “Early Payment Default, Repurchase and the Impact on Home Equity ABS,” Credit Suisse Fixed Income Research, September 5.
- Davis, Terri, 2001, “Mortgage Focus 2001,” Fannie Mae.
- Doms, M., and Meryl Motika, 2006, “The Rise in Homeownership,” Economic Letter, Federal Reserve Bank of San Francisco, 2006-30, November.
- Eggert, Kurt, 2007, “Subprime Mortgage Turmoil: Examining the Role of Securitization,” written testimony to the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affairs, April 17.
- Engel, Kathleen C., and Patricia A. McCoy, 2007, “Turning a Blind Eye: Wall Street Finance of Predatory Lending” Fordham Law Review, March, 101-165.
- Goldstein, Debbie, and Stacy Strohauer Son, 2003, “Why Prepayment Penalties are Abusive in Subprime Home Loans,” Center for Responsible Lending Policy Paper No. 4.
- Gramlich, Edward M., 2004, “Subprime Mortgage Lending: Benefits, Costs, and Challenges,” Remarks, Financial Services Roundtable Annual Housing Policy Meeting, Chicago, May 21.
- Harney, Kenneth R., 2007, “Credit Scores for Sale,” Washington Post, April 7, F01.
- Klyuev, Vladimir and Paul Mills, 2006, “Is Housing Wealth an ‘ATM’? The Relationship Between Household Wealth, Home Equity Withdrawal and Savings Rates,” International Monetary Fund Working Paper WP/06/162, June.
- Kogler, Bernadette, Ann Schnare and Tim Willis, 2006, “Lender Perspectives on FHA’s Declining Market Share”, Research Institute for Housing America, August.
- LaCour-Little, Michael, 2000, “The Evolving Role of Technology in Mortgage Finance,” Journal of Housing Research, Vol. 11, No. 2, 173-205.
- Lehman Brothers, 2007, “Will Subprime Woes Spill Over to the Broad Markets,” Lehman Brothers Fixed Income Research, March 8.
- Mason, Joseph R. and Joshua Rosner, 2007a, “How Resilient are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?” Paper presented at the Hudson Institute, February 15.
- Mason, Joseph R. and Joshua Rosner, 2007b, “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions,” Paper presented at the Hudson Institute, May.
- Pennington-Cross, Anthony, 2003, “Credit History and the Performance of Prime and Nonprime Mortgages,” Journal of Real Estate Finance and Economics, Vol. 27, No. 3, 279-301.
- Peterson, Christopher L., 2007, “Subprime Mortgage Turmoil: Examining the Role of Securitization,” written testimony to the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affairs, April 17.
- Quigley, John M., 2006, “Federal Credit and Insurance Programs: Housing,” Federal Reserve Bank of St. Louis Review, July/August, 281-309.
- Scholtes, Saskia, 2007, “Fears over a helping hand for home loan defaulters,” Financial Times, June 1.
- Zimmerman, Thomas, 2007, “The U.S. Subprime Market: An Industry in Turmoil,” UBS Securitized Products Strategy Group, March.

*Source: _wp07188 - References*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07188.pdf_