Studies: Subprime Mortgages Failed Main Goalby Tim Manni
According to a recent article in National Mortgage News, two separate studies revealed that subprime mortgages failed to accomplish the main goal of their design — putting people into homes. The studies revealed that the “temporary nature of these loans” combined with the lack of “soft information” collected by lenders, contributed to subprime’s short life expectancy.
Yuliya S. Demyanyk, a Senior Research Economist for the Federal Reserve Bank (FRB) of Cleveland, published a paper for the FRB of St. Louis which found that between the years 2001 and 2006, nearly 80% of subprime loans exited the marketplace within three years. Demyanyk’s research found that the high “exit rate,” even when it was into more prime or “more stable subprime” loans, reveals the temporary nature of these loans. Less-qualified borrowers tended to use their subprime loans more as “bridge loans”, a kind of temporary financing. The fact that subprime loans carry such high interest rates, fees, and prepayment penalties motivated most to refinance out of their costly loan as soon as possible.
A separate study conducted by the University of Michigan, the University of Chicago, and the London Business School determined that the lack of “soft information” collected from borrowers also led to high default rates:
…statistical models that were used to predict defaults in subprime loans failed because they relied too much on credit scores and loan-to-value ratios and not enough on “soft information” that originators gained in personal contact with the borrowers.
The authors of the report make the case that securitization took away the incentive to collect soft information. The loan is sold to a third party, so the lender no longer bears the risk of default.
Determining a borrower’s soft information includes going beyond their credit score and LTV and examining their risks of unemployment, behavioral issues, as well as any unexpected future expenses that could hamper their ability to pay back the loan.
“Face-to-face interviews of borrowers by experienced originators always played a key role in the quality of a loan. The studies suggest that automation and mechanization still can’t replace good judgment,” said HSH Vice President Keith Gumbinger.
While the high default rates on subprime loans shouldn’t come as shock, it’s important to acknowledge the factors which contributed to the failed structure of this particular loan product. Hopefully this information will help the mortgage industry avoid making the same mistakes twice.