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The Rise and Fall of Subprime
The Subprime Mortgage Meltdown of 2007
Frank E. Nothaft*

       Abstract: The subprime segment of the single-family housing market experienced relatively high delinquency rates in 2000 and
       2001 before rates declined for the 2002 and 2003 origination books. This article discusses trends in the subprime segment
       over the last several years, including the large increase in origination volume, deterioration in underwriting standards and
       subsequent increase in delinquency rates to record levels in 2007.

Perspectives from 2001                                           first-lien conventional conforming originations slipped
Economic growth slowed abruptly, after years of                  from $1.3 trillion in 2001 to $1.0 trillion in 2006.
expansion. Some subprime lenders were accused of
                                                                 Product and Borrower Characteristics Differ Greatly
predatory lending tactics and shoddy underwriting.
                                                                      The loan products originated in the prime
Subprime defaults were up sharply, and sizable amounts
                                                                 conventional, alt-A, and subprime segments are very
of some subprime portfolios were written off.
                                                                 different. Chart 2-2 summarizes the product mix for
     Yes, 2001 was a difficult year for both subprime
                                                                 purchase-money loans originated during 2006 for each
borrowers and investors. Large financial institutions had
                                                                 of these segments. For prime conventional, 70% of the
acquired The Money Store (First Union), The Associates
                                                                 dollar volume of loans were long-term fixed-rate,
(Citigroup), Champion Mortgage (KeyCorp) and other
                                                                 primarily 30-year term, and the most               common
mortgage companies that had specialized in subprime
                                                                 Adjustable-Rate Mortgage (ARM) was the 5/1
lending during the late 1990s and had not anticipated
                                                                 (accounting for nearly one-half of hybrid ARMs),
that serious default rates (percent of loans delinquent 90
days or more, or in foreclosure)
                                                                                Chart 2-1
would rise from 5% or that loans               Subprime and Alt-A Originations Shares Have Quadrupled Since 2001
serviced at the beginning of 2000
would rise to 8% by early 2002.1
Those depositories that had acquired
these firms wrote off large amounts
in 2001 to account for the losses
accruing on subprime portfolios.
     In 2001, as credit standards
tightened, subprime loans accounted
for about 5%, and alt-A2 an
additional 3%, of the $2.2 trillion
single-family origination market.
Subprime lending volume quintupled
in the ensuing five years: By 2006,
the subprime and alt-A shares had
expanded to one-third of a $3.0
trillion single-family origination
market, as shown in Chart 2-1.
Despite the growth in overall volume Source: Inside Mortgage Finance (by dollar amount)
of home mortgage lending, prime
* Vice President and Chief Economist, Freddie Mac. Opinions, estimates, forecasts and other views contained in this article are my own and do
  not necessarily represent the views of Freddie Mac or its management, should not be construed as indicating Freddie Mac’s business prospects
  or expected results, and are subject to change without notice. Although Freddie Mac’s Office of the Chief Economist attempts to provide
  reliable, useful information, it does not guarantee that the information is accurate, current or suitable for any particular purpose.
    Serious default rates are based on data collected by LoanPerformance.
    “Alt-A” is the segment of the mortgage market that falls between prime and subprime and is sometimes referred to as “Alternative-A” in comparison to “A-
    credit.” Borrowers that have taken out mortgages that fell into this segment usually did not submit all the documentation that would qualify for an A-credit loan,
    because they might not have a steady stream of income or could not show enough documentation of their income sources.

RESEARCH REVIEW, VOL. 14, NO. 3, 2007                                                                                                                               7

                                  Chart 2-2                                            ethnicity trends are apparent even after controlling for
    Hybrid Adjustable-Rate Mortgages Dominate Subprime                                 relative income ranges.
          Home-Purchase Loan Originations in 2006                                         The neighborhood distribution of high-coupon loans
                                                                                       mirror that of Chart 2-3. In short, high-coupon loans are
                                                                                       more prevalent in neighborhoods with a higher minority
                                                                                       share of the population, or in low-income
                                                                                       neighborhoods. For example, as shown in Chart 2-4,
                                                                                       high-yield loans represented 40% of loans made in low-
                                                                                       income areas (median family income of census tract at
                                                                                       or below 80% of the Metropolitan Statistical Area
                                                                                       (MSA) median) compared with 18% of loans in higher-
                                                                                       income areas (tract income above 120% of the MSA
                                                                                       Risk Layering, Underwriting and Loan Performance
Sources: LoanPerformance, a subsidiary of First American Real
Estate Solutions, TrueStandings Securities; MIRS. First liens only, by                    Several factors contributed to the quadrupling of the
dollar amount.                                                                         subprime and alt-A shares of loan originations between
                                                                                       2001 and 2006. One was the decline in subprime default
providing the borrower with five years of protection
                                                                                       rates beginning in 2003 and flood of liquidity in the
from interest-rate risk and annual payment adjustments
                                                                                       global capital markets, both of which lowered credit-risk
thereafter. Within the alt-A segment, fixed-rate loans
                                                                                       spreads and, hence, the cost of obtaining subprime loans.
comprised about one-third of originations and ARMs
                                                                                       And another important factor was the increasing layering
two-thirds.     For subprime loans in private-label
                                                                                       of risk within applications and competitive pressures to
Mortgage Backed Securities (MBS), 91% were ARM,
                                                                                       originate loans in a market where the number of
with about one-half the 2/28 hybrid variety: two years of
                                                                                       borrowers was shrinking, placing pressure on appraisers
a fixed rate, followed by payment resets usually every
                                                                                       to hit certain values and on underwriters to approve
six months thereafter and sometimes more frequently. It
                                                                                       higher-risk loans.
is also common that the latter product has prepayment
penalties if the loan is prepaid within three years from                                                              Chart 2-3
origination, whereas such penalties are uncommon in the                                 Share of Subprime Loans By Ethnic Group and Income
prime conventional segment.                                                                                Bracket—2006
   Examining high-coupon mortgages identified in the
Home Mortgage Disclosure Act (HMDA) data provides
an opportunity to examine demographic and location
characteristics of borrowers with such loans.3 While
lenders submitting HMDA data do not indicate whether
the loan was subprime, the high-yields reported are a
proxy that should correlate well with the likelihood that
the loan is subprime. Using the most recent (2006)
HMDA data available, Chart 2-3 summarizes the income
and race/ethnicity characteristics of borrowers with high-
coupon loans and highlights three findings. First,
African-American and Hispanic borrowers are far more
likely to have taken out high-coupon mortgages than
non-Hispanic whites and Asian Americans, with close to
one-half of African-Americans having high-coupon
loans. Second, low- and moderate-income borrowers are                               Source: 2006 Home Mortgage Disclosure Act data. Single-family,
more likely to have high-coupon loans. Third, the race/                             conventional, 1st liens, purchases and refinances.
    A high-coupon loan is any loan for which the annual percentage rate (APR) is three percentage points or more above the comparable term Treasury yield. For
    example, during 2006, the average Treasury security yield to use with a 30-year mortgage was 4.90% and the Treasury yield to use for a 15-year mortgage was
    4.82%. In contrast, the average rate for a prime conventional, conforming 30-year fixed-rate mortgage during 2006 was 6.41% with an average of 0.5 points
    paid in fees and discount, and the average rate for a prime, conventional conforming 15-year fixed-rate mortgage was 6.07% with 0.5 points (based on Freddie
    Mac’s Primary Mortgage Market Survey). Thus, any 30-year fixed-rate loan with an APR more than 300 basis points above the 30-year Treasury yield when the
    mortgage rate was locked in would be reported as a high-yield loan; these would be loans that would likely have a contract rate that was at least 150 basis points
    above a prime, conventional conforming loan.

RESEARCH REVIEW, VOL. 14, NO. 3, 2007                                                                                                                               8

                                 Chart 2-4                                    “prime” (perhaps alt-A) borrowers may have been
           Two in Five Loans Originated in Low-Income                         included to raise the mean score and lower the perceived
             Neighborhoods Were Subprime in 2006                              credit risk on the pools; further, with expanded use of
                                                                              low- and no-doc lending, co-borrowers with weak credit
                                                                              scores may have been dropped from the FICO
                                                                                  Strong house-price appreciation often offsets a
                                                                              deterioration in underwriting quality, but as appreciation
                                                                              slowed sharply over the past year and prices turned
                                                                              lower in a number of markets, the weakness of risk
                                                                              layering became exposed. In particular, a number of
                                                                              price measures have clearly shown that house prices fell
                                                                              over the past year in New England, the East North
                                                                              Central region (especially Michigan and Ohio), and in
  Source: Home Mortgage Disclosure Act (2006).
                                                                              some previous high-flying states in the West (California
                                                                              and Nevada). These value declines have highlighted the
    The increased layering of credit-risk attributes over                     dangers of risk layering. Early-payment defaults on
time is suggested by the data in Chart 2-5. Each row                          recent subprime vintages have moved sharply higher, as
represents an origination year cohort (from 2001 to                           shown in Chart 2-6, based on Moody’s analysis of
2006) with the average characteristics of first-lien,                         private-label MBS it had rated. In particular, the percent
purchase-money loans placed in private-label subprime                         of loans in foreclosure within six months of origination
MBS arrayed across the columns. Some telltale signs of                        had more than tripled when comparing subprime loans
increasing layering of risk through 2005 are evident:                         made during the second quarter of 2004 with those in the
increasing use of ARMs (especially interest-only                              same quarter of 2006.
ARMs), higher non-owner occupant and debt-to-income                               The significant rise in defaults has already been
shares, and a near doubling in low- or no-doc lending.                        evident in the broader market gauges of loan
The relatively stable average first-lien loan-to-value                        delinquency. The Mortgage Banker’s Association’s
(LTV) ratio masks the tendency to rely on home-equity                         (MBA) National Delinquency Survey, which currently
loans and other forms of second-lien financing.4 The                          processes information on over 44 million first-lien loans,
average FICO5 score at origination appears to move                            has shown a sharp rise in the number of loans entering
higher but may be a misleading indicator because some                         foreclosure proceedings in the past year. Chart 2-7
                                                   Chart 2-5
                                                                                                       summarizes the trend in
             More Risk Layering in Subprime Home-Purchase Loans Since 2001                             foreclosures started since mid-
 Origination        ARM      Interest Only Non-Owner Low/No-Doc Debt-To- Average Average
                                                                                                       2003, by the three main
    Year           Share      ARM Share          Share        Share        Income      LTV      FICO   segments of the single-family
                                                                                                       market. The overall number of
                                                                                                       prime (bottom part of each bar)
    2001            73.6%          0.0%           7.1%         28.5%         39.7       84       621   and Federal Housing
    2002            79.8%          2.3%           7.6%         38.5%         40.1      84.4      638   Administration (FHA) and
                                                                                                       Department of Veterans
    2003            80.0%          8.6%           8.5%         42.8%         40.5       86       650   Affairs (VA) (middle segment
    2004            89.3%         27.3%           8.8%         45.1%         41.1      84.8      650   of each bar) loans entering
                                                                                                       foreclosure has changed
    2005            93.1%         37.8%           9.4%         50.7%         41.7      83.1      650   relatively little since then,
    2006            90.6%         22.2%           8.2%         51.3%         42.5      83.5      646   running at close to 400,000 at
                                                                                                       an annualized rate. In contrast,
   2007H1           88.7%         23.1%           7.9%         42.8%         42.6      85.6      644   the number of subprime loans
Source: LoanPerformance, a subsidiary of First American Real Estate Solutions, TrueStandings entering foreclosure has moved
Securities. First-lien originations; by dollar amount. MBS issued through June 2007.                   sharply higher over the past
    Data on second liens and total LTV are not available in LoanPerformance’s TrueStandings application.
    A FICO score is a credit rating developed by the Fair Isaac Corporation (hence the FICO name), which is used widely by the credit bureaus in the United States
    (but is expanding globally). FICO scores are calculated based on information in the consumer’s credit report, such as: payment history, current level of
    indebtedness, types of credit used and length of credit history.

RESEARCH REVIEW, VOL. 14, NO. 3, 2007                                                                                                                           9

                                            Chart 2-6                                           lending clearly have tightened their
      Subprime Early Foreclosure, Real Estate Owned, Loss and Severe Delinquencies              underwriting practices since the
                                                                                                beginning of the year. The Federal
                                                                                               Reserve’s       April 2007 Senior Loan
                                                                                               Officer Opinion Survey of domestic banks
                                                                                               found that 56% of banks that made
                                                                                               subprime loans reported they had
                                                                                               tightened their credit standards for this
                                                                                               product over the preceding three months,
                                                                                               and 46% had tightened their
                                                                                               nontraditional (e.g., interest-only and alt-
                                                                                               A) standards, and the July survey
                                                                                               reported further tightening on these
                                                                                               products during the intervening three-
                                                                                               month interval; in contrast, about 85% of
                                                                                               senior officers said their prime credit
                                                                                               standards had remained basically
                                                                                                unchanged in the April and July surveys.6
Source: Structured Finance by Moody’s Investor Service (January 18, 2007.)                      Any underwriting changes that may
* Includes only deals closed in April and May 2006.
                                                                                                occur in the traditional prime market may
                                                                                                likely be in the form of requiring some
two years, and has more than doubled between the first                           down payment on the part of the homebuyer. There
half of 2005 and the same period in 2007. Subprime,                              have been some anecdotal reports that no-down
which comprises 14% of the loans reported in the                                 piggyback financing, such as 80-20 first-second liens,
MBA’s survey, accounted for 56% of the single-family                             are harder to come by. The move toward significant
loans entering foreclosure during the first six months of                        tightening of subprime underwriting is reminiscent of
2007. Given the elevated early-payment default rates on                          what occurred during 2001 and 2002 in the subprime
recent subprime vintages, and the likelihood of further                          segment as well.
price weakness in major markets around the U.S., it is                              The main reason that the traditional prime
likely that foreclosures will rise further in 2007. By                           conforming market is likely to be relatively unscathed is
simply extrapolating the 2006H1-to-2006H2 change in                              the prominent roles played by Freddie Mac and Fannie
number of foreclosures by each of the                                                             Chart 2-7
three main single-family segments                                                     Number of Foreclosures Started
through to 2007H1-to-2007H2, this would                                                 (Annualized Rate in Thousands)
indicate that over one million loans will
start foreclosure proceedings in 2007 and
nearly 60% of these will be subprime
Will There be a Spillover to Prime or
the Broader Economy?
   The shakeout in the subprime segment
has already closed a number of lenders
with questionable underwriting practices
and fostered closer scrutiny on the
accuracy of appraisals. Some private
investment funds have acquired or stepped
up their investment in some firms,
providing the credit lines for a
continuation of lending but, presumably,
                                                            Source: Mortgage Banker’s Association National Delinquency Survey; Freddie Mac projection
with more prudent standards. Banks that                     extrapolates 2006H1 to 2006H2 foreclosure change to 2007H1 to 2007H2.
have been active in subprime and alt-A

RESEARCH REVIEW, VOL. 14, NO. 3, 2007                                                                                                             10

Mae in setting prudent underwriting criteria and                                  the second half of 2007. However, much of the
providing liquidity to support this segment. While                                inventory overhang should be absorbed by the middle of
foreclosures will likely rise in the coming year within                           next year, and household formations have remained
the traditional prime segment, it will reflect the broader                        strong. Immigration, in particular, has been robust, with
macroeconomic slowdown and home-value weakness in                                 legal immigrants totaling a 15-year high of 1.3 million
various markets, rather than a contagion that has                                 during 2006; Harvard’s Joint Center for Housing
infected the prime, conforming segment. Nonetheless,                              Studies has projected 1.2 million immigrants to the U.S.
any neighborhood with a large number of subprime                                  each year through 2015, which, if achieved, would set a
loans can be in for a downward home-value shock if                                record for a 10-year period.7 Strong immigration and
these loans enter foreclosure proceedings all at once; the                        household formations will support a housing sector
depressing effect on values could trigger additional                              recovery during 2009, albeit at a level of construction
foreclosures on prime loans that might otherwise have                             and sales that will remain well below the record levels
weathered the financial storm.                                                    of 2005.
    Effects on the housing market are likely to be felt at                             Effects on the financial markets have been severe
least through 2008, if not longer. The aggressive                                 over the latter half of the third quarter, with a freeze-up
lending in the subprime segment, especially in 2005 and                           of private-label MBS issuance leading to a spike in
2006, likely accelerated home building and sales that                             jumbo yields and for Commercial Mortgage Backed
would have occurred at later dates, adding to the                                 Securities (CMBS). In particular, spreads between
economic stimulus from housing in those years. Home                               jumbo and conforming fixed-rate loans jumped from
building, including mobile home shipments, hit 2.2                                about a quarter of a percentage point to a full percentage
million homes during 2005, above the level that could                             point in August, an unprecedented spread in the 20
be supported by the then-rate of household formations                             years that this information has been recorded. CMBS
and the projected trend of growth rate in households.                             spreads to benchmark securities also blew out during
With the resulting oversupply that has affected a                                 August: for BBB-rated tranches, the spread to 10-year
number of markets, new construction will be much                                  Treasury yields peaked at a record 4.5 percentage points
weaker in the coming year and may not begin to recover                            at the end of August, more than three times the average
until the end of 2008. The downshift in residential fixed                         spread during 2006.8 If the market disruptions of the
investment (primarily construction spending, but also                             fall of 1998 are any guide, it may take two to three years
lessened home-sales volume) has subtracted about one                              for CMBS and jumbo spreads to return to more normal
percentage point from GDP growth over the past four                               levels on the heels of a more balanced housing market.
quarters and will continue to be a drag on growth over

                  Frank E. Nothaft is Vice President and Chief Economist of Freddie Mac, a stockholder-owned
                  corporation established by Congress in 1970 to increase the availability of mortgage money in support
                  of home ownership and rental housing. Before joining Freddie Mac, he was an Economist with the
                  Board of Governors of the Federal Reserve System.

    U.S. Department of Homeland Security,, Table 1; and George S. Masnick and Eric S. Belsky,
    “Revised Interim Joint Center Household Projections.” Joint Center for Housing Studies of Harvard University, Publication N06-1, March 2006,
    The interest-rate spread between jumbo and conforming 30-year, fixed-rate mortgages was obtained from HSH Associates; adjusting for up-front points, the
    effective spread was a record 96 basis points for the week ending August 31. CMBS spreads to 10-year Treasury yields by tranche rating were obtained from
    Morgan Stanley; the spread for BBB-rated tranches hit a record 446 basis points the week ending August 31.

RESEARCH REVIEW, VOL. 14, NO. 3, 2007                                                                                                                    11

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