Will low-income homebuyers gain or lose when Fannie Mae and Freddie Mac move into the subprime lending market?
By Allen J. Fishbein
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|The recent foray into the subprime mortgage market by Fannie Mae and Freddie Mac has renewed the debate over their role in the affordable housing arena. The subprime market targets borrowers with credit problems or limited credit histories who do not qualify for cheaper, prime loans. Fannie and Freddie traditionally have purchased a small share of these loans, but this figure is expected to grow significantly in the next few years. Proponents say that the two huge intermediaries can bring better pricing for some subprime borrowers and help to curb predatory lending. Competitors and some analysts say they will only cream the least risky borrowers, making other subprime loans even more costly to borrowers who need them. Still others forecast that a bigger role in the subprime market may pave the way for making traditional prime loans more expensive for some borrowers.
Fannie Mae and Freddie Mac are for-profit, privately capitalized government-sponsored enterprises (GSEs) chartered by Congress to act as intermediary institutions for residential mortgages (at present that means conventional mortgages under $300,700).
By law, the GSEs must make affordable housing part of their business (see SF #80). The GSEs do not make mortgage loans directly to individual borrowers. Instead they perform their secondary market function by buying mortgages from banks, savings institutions and other mortgage lenders. They either keep these loans in their own portfolios or, more typically, package the loans in pools and sell them to investors as mortgage-backed securities. These functions, in turn, provide lenders with the funds needed to issue new mortgages, thus bringing additional capital into the housing loan market. For the mortgages to be packaged and sold as securities, they must meet certain standardized underwriting criteria set by the GSEs. The combined purchases by GSEs in recent years have ranged well over 50 percent of all conventional mortgage activity and this year may hit as much as 71 percent of the market. As a result, Fannie Mae and Freddie Mac have a tremendous degree of influence over which types of borrowers have access to different types of mortgage credit and on what terms.
The overall conventional mortgage market (nongovernment insured or guaranteed) is comprised of two broad categories of loans, prime and subprime. Prime mortgages constitute the largest category, representing loans to borrowers with what lenders regard as good credit (A quality, or investment grade). Everything else is subprime loans to borrowers who have a history of credit problems, insufficient credit history, or nontraditional credit sources. Subprime mortgages are rated by their perceived risk, from the least risky to the greatest risk: A-minus, B, C, and even D. However, A-minus loans account for 50 to 60 percent of the entire subprime market.
Subprime borrowers frequently pay higher points and fees and are saddled with more unfavorable terms and conditions, such as balloon payments, high prepayment penalties, and negative amortization. Lenders say the higher rates and charges reflect the additional costs and risks of lending to borrowers with less than perfect or nonconventional credit. However, research conducted by Freddie Mac suggests that the higher interest rates charged by subprime lenders are in excess of the additional risks these borrowers bear. Thus, increased competition would tend to reduce borrowing costs in the subprime market.
A Growing Market
Subprime lending has grown rapidly in the past decade as a segment within the conventional mortgage market. Last year, lenders originated about $173 billion in subprime loans, up from just $25 billion in 1993. A recent study by the Center for Community Change found wide racial disparities in subprime lending, with African-American and Hispanic homeowners disproportionately represented. While 25 percent of all home refinance loans in 2000 were subprime, the percentage jumped to nearly 50 percent for African-Americans and 30 percent for Hispanics.
Interestingly, subprime market growth in the 1990s occurred largely without the participation of Fannie Mae and Freddie Mac. The GSEs started showing interest in this market toward the end of the decade and now purchase A-minus mortgages as a regular part of their business. National Mortgage News, a trade publication, estimates their combined market share in 2001 grew by 74 percent, representing about 11.5 percent of all subprime loan originations in that year. Some market analysts estimate that GSEs will soon be purchasing as much as one-half of all subprime originations.
The expansion of subprime lending provides credit access for many borrowers unable to obtain prime loans. However, it has also triggered a rise in exploitative and predatory practices that are stripping borrowers of home equity they may have spent a lifetime building (see SF #109). Studies by the National Training and Information Center, HUD and others showing extremely high foreclosure rates on subprime loans suggest that predatory lending is a serious problem and that many subprime borrowers are entering into mortgage loans they cannot afford.
Benefit to Borrowers
The GSEs say their stronger presence in the subprime market will create lower priced mortgages for some subprime borrowers. Two types of borrowers would appear to benefit the most from this. First, the near A risk or A-minus borrowers; both Fannie Mae and Freddie Mac have suggested that a significant portion of these borrowers have credit histories that would qualify them for cheaper prime loans. The next to benefit would be the grade A credit borrowers who do not know that they qualify for prime loans and therefore may turn to subprime lenders. The absence of active mainstream prime lenders in many minority and low-income markets has increased the chances that A borrowers in these areas are paying more than they should. Greater GSE activity in the subprime market may help to channel more of these into cheaper prime loans.
GSEs also have vowed not to buy subprime mortgages with certain predatory features, which has garnered support from many consumer and community advocates. The impact of these measures may be limited because the GSEs have indicated they will avoid the riskier end of the subprime market, where abuses are most likely to occur. Some subprime borrowers also will benefit from greater standardization of loan terms and underwriting, which would make the subprime market function more like the prime market does today. Shoppers would be able to more readily compare pricing from competing lenders to find the best deal, but again these advantages may not be available to borrowers who are only eligible for B and C loans.
GSE Benefit and Risk-based Pricing
The motivation for GSEs to increase their subprime niche seems logical enough. Their traditional market of conventional prime mortgages has matured, and they are looking for new ways to sustain the past decades economic success and investor expectations. For GSEs, the subprime market presents a relatively untapped and still growing market. Because their public charter enables them to raise funds more cheaply than fully private financial institutions, GSEs can be expected to expand their market share by outpricing their competitors.
GSE interest in the subprime market is also driven by their desire to find new applications for automated underwriting (AU) systems. AU systems represent the fusion of statistical credit scoring methods with high-tech processing. They are intended to improve the ability of GSEs to rank borrower risk and to determine eligibility standards for loan purchases. Both GSEs launched their systems in the mid-1990s, and they quickly replaced the traditional manual approach to making loan decisions. The Fannie Mae AU system is known as Desktop Underwriter; the Freddie Mac version is known as Loan Prospector. Each system relies upon numerical credit scores, loan to value ratios and other data submitted by the borrower to calculate a mortgage score. These scores, in effect, represent the judgment of the GSE about its willingness to accept the loan application, or to refer it for further review through more costly manual underwriting. Most GSE purchases have been approved through one or the other of these AU systems.
AU systems are intended to speed loan processing, reduce costs for lenders (and presumably borrowers) and reduce opportunities for bias to creep into the loan decision-making process. The GSEs point to increasingly higher acceptance rates as evidence that these systems are expanding opportunities for approval of more marginal, yet creditworthy, applications. But to enter the subprime market, the GSEs have had to modify their AU systems so that the prime lenders they deal with can approve slightly higher-risk borrowers, whose applications would not have been accepted in the past. The GSEs charge lenders higher fees for making these loans, and mortgage originators in turn may pass these higher costs along to borrowers. Thus, these higher-risk loans are priced above those offered to prime borrowers but below what subprime lenders would otherwise charge for these loans.
Using AU to set prices for making loans with different risks is a form of risk-based pricing. It represents an important change in the way the GSEs have traditionally operated their prime loan business. For the most part, prime mortgage borrowers are charged interest rates based on what is called average loan pricing. In other words, a borrower approved for a mortgage receives about the same interest rate regardless of the risk of loss to the lender. The risk for all prime lenders, from the lowest to the highest, is averaged, and the interest rate is set based on the average risk.
Risk-based pricing lends itself to the new technologies the GSEs have developed. Borrowers are bunched in smaller pricing buckets based on their calculated risk and potentially other factors, such as the loans expected lifetime rate of return. Until now, the GSEs have met resistance to this new system from lenders and borrowers alike. However, risk-based pricing for subprime loans would seem to have more appeal to borrowers if it leads to reductions in the price of other loan products.
Why Others May Pay More
As the price declines for certain subprime loans, the traditional distinctions between prime and subprime loans will become less important. The price of mortgages formerly considered subprime will be based instead on the ease with which they can be sold to one of the GSEs.
However, other subprime loans, such as the B and C loans that GSEs do not buy, may become more expensive for borrowers. As the GSEs capture the market for less risky subprime borrowers, it will leave fewer of them available to cross-subsidize the costs of making subprime loans to more risky borrowers. Subprime lenders, therefore, are likely to attempt to recapture their loss of income by raising rates for the segment of the market they continue to serve. Thus, some of the neediest borrowers may find themselves paying even more as a result of GSE entry into the subprime market.
Risk-based pricing for subprime loans may also hasten the demise of average pricing for prime lending as well. As the prime/subprime distinction blurs, borrowers who today just barely qualify for conventional prime loans (and thereby are charged the same interest rate as any other prime borrower) may find that there no longer is a single class of prime borrowers, but rather a continuum of pricing categories. Thus, the movement to risk-based pricing would benefit some borrowers, but lead to others paying more. More consideration is needed of this overall substitution effect on the entire mortgage market, and of how minorities and other traditionally underserved borrowers would fare in a switch to risk-based pricing.
Finally, the movement to risk-based pricing for mortgages raises fundamental concerns about whether the AU systems are biased against minorities and other protected classes. Fannie Mae and Freddie Mac strongly maintain that they are not, but these concerns will remain, at least until an independent agency with the necessary analytical expertise and no particular axe to grind makes an informed judgment.
Indications are that credit-scoring tends to work against families with limited or alternative credit histories, which are disproportionately represented by African-American and Hispanic households. Questions also persist as to whether the statistical measures of creditworthiness being used are the best predictors of mortgage repayment for all applicants. The fact that the weighting for the factors used for credit and mortgages scoring are not truly transparent to borrowers reinforces these concerns.
The U.S. Department of Housing and Urban Development (HUD), which serves as the housing mission and fair lending regulator for the GSEs, perhaps is in the best position to answer these critical questions. But thus far, it has chosen not to. In 2000, HUD completed a comprehensive fair lending review of each AU system. Inexplicably, HUD has yet to release the results. Since so much of mortgage lending is affected directly or indirectly by these systems, the release of the reviews findings is long overdue. Fair housing and affordable housing advocates should press for this information to be released.
HUD also needs to enhance its ability to monitor the increase in GSE subprime loan purchases. While HUD currently collects loan level data about GSE loan purchases, this reporting at present does not provide the details about pricing and loan terms needed to permit effective monitoring of their subprime activity. Are the GSEs in compliance with their own standards and HUD rules regarding the purchase of loans with predatory features? Are subprime borrowers benefiting from a larger GSE role? These are questions the agency should have the necessary information to answer. Expanding the public database for this information also would help.
It is ironic that, with all of the talk in Washington about investor need for greater transparency about the capital market activities of the GSEs, the discussion does not extend to finding ways to improve the monitoring of their loan purchase activity. Yet this is precisely what is needed to judge the impact of automated underwriting, risk-based pricing, and increased GSE subprime activity on affordable housing and credit access by underserved groups.
Allen Fishbein is general counsel of the Center for Community Change and co-directs its Neighborhood Revitalization Project. From 1999-2000 he was a senior advisor for Government Sponsored Enterprises Oversight at HUD, where he helped supervise the establishment of new affordable housing goals for Fannie Mae and Freddie Mac.
Fannie Mae, 3900 Wisconsin Avenue, NW, Washington, DC 20016-2892.
Subprime Foreclosures: The Smoking Gun of Predatory Lending? HUD, July 2002.
Homeowners have always been able to develop a solid credit history simply by paying their mortgage on time. Now, renters who pay their rent on time will have a chance to build on their own good record.
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