Subprime Borrowers Research Articles

Predatory Lending and the Subprime Crisis

We measure the effect of an anti-predatory pilot program (Chicago, 2006) on mortgage default rates to test whether predatory lending was a key element in fueling the subprime crisis. Under the program, risky borrowers and/or risky mortgage contracts triggered review sessions by housing counselors who shared their findings with the state regulator. The pilot cut market activity in half, largely through the exit of lenders specializing in risky loans and through decline in the share of subprime borrowers. Our results suggest that predatory lending practices contributed to high mortgage default rates among sub prime borrowers, raising them by about a third.

The Impact of House Prices on Consumer Credit: Evidence from an Internet Bank

This paper shows that house price fluctuations can have a significant impact on credit markets well beyond the mortgage segment. Using new data from Prosper.com, a peer to peer lending site that matches borrowers and lenders to provide unsecured consumer loans, we find evidence that home owners in states with declining house prices face higher interest rates and greater rationing of credit, while also becoming delinquent faster. Investigating the mechanism, we find separate supply and demand effects, and especially large effects for those subprime borrowers whose balance sheets are likely to be most exposed to asset price declines. This evidence suggests that asset price fluctuations can play an important part in determining credit conditions and are thus a potentially significant mechanism for propagating macroeconomic shocks.

Detecting and explaining systemic risks of mortgage banks—evidence from the subprime crisis

In recent history, financial markets worldwide experienced severe turmoil due to the subprime crisis originating from the practice of US mortgage banks to securitize loans given especially to subprime borrowers. In the same crisis, several distressed banks were bailed out by states with even more banks receiving financial aids from governments. Using a unique data sample of 100 announcements of US mortgage banks between 2006 and 2009, this paper provides empirical evidence that isolated failures of US mortgage banks caused significant contagion effects in the US financial system. Conversely, especially the bailouts of Fannie Mae and Freddie Mac led to significant positive valuation effects at rival banks. In the cross-sectional analyses, contrary to previous studies in the literature on past financial crises, we find evidence for pure contagion effects following the failures of US mortgage banks. Furthermore, we analyze the reactions of the CDS spreads of several large US banks to the announcements of mortgage banks using a novel mixture copula model. The results show that the contagion effects were limited to the stock market thus underlining the notion of an irrational response of (stock) market participants. The results from our cross-sectional and CDS data analyses in turn indicate that several of the failures of US mortgage banks during the subprime crisis caused irrational contagion in the US financial system thus justifying government intervention. Finally, we rule out the possibility that the contagion effects limited to the US stock market were caused by a herding of investors.

Gender, age, and race in subprime America

For almost 20 years, evidence from journalists' reports, Congressional testimony, and consumer protection litigation suggested that predatory practices in the subprime market were especially harmful for elderly African American women, many of them widows. Much of this evidence has been dismissed as anecdotal, however, and lending research has generally ignored feminist theory – obscuring the relations among race/ethnicity, gender, and age. In this paper, we draw on two complementary datasets to test the hypothesis that subprime inequalities were intensified for African American women. Analysis of Home Mortgage Disclosure Act (HMDA) data confirms that gender inequalities exacerbate racial/ethnic inequalities in the segmentation of high-cost subprime credit, while the National Mortgage Data Repository provides limited circumstantial evidence of disproportionate representation of elderly African American women. Loan terms among subprime borrowers in the NMDR display only modest variations by gender and race/ethnicity, however, although there is some evidence of bait-and-switch tactics and persistently higher total fees among African American women. The veneer of equal treatment within an exploitative subprime market conceals the wider context of structural inequalities of race/ethnicity, gender, and age in housing and credit.

The global financial crisis: Some suggestions for reform of the global financial architecture in the light of Islamic finance

AbstractThe article argues that the primary cause of the current subprime mortgage crisis in the United States is the absence of adequate market discipline in the financial system. This tends to promote excessive lending, high leverage, speculation, and an unsustainable rise in asset prices. Unwinding later on gives rise to a vicious cycle of selling that feeds on itself and leads to a steep decline in asset prices followed by financial crisis and economic slowdown. The solution lies in introducing risk sharing along with the availability of credit for primarily the purchase of real goods and services that Islamic finance aims at introducing. This can help inject greater discipline into the system and, thereby, substantially reduce financial instability. Since the introduction of greater discipline into the financial system may deprive the subprime borrowers of credit, the article also discusses the need for finding ways of satisfying their genuine credit needs. © 2011 Wiley Periodicals, Inc.

Household behavior and boom/bust cycles

I describe household behavior in boom and bust economic cycles with a particular focus on the recent financial crisis. The behaviors are motivated by cognitive limitations and psychological bias. In boom times, households’ extrapolation bias and groupthink lead to chasing and extending asset bubbles (like tech stocks and real estate). Increasing use of debt spurs the economy and eventually overburdens households. In bust times, the biases and fear lead to selling previously popular assets at low prices. Households generally respond to bust times by spending less, repaying debt and saving more, which drags on an already slow economy. In addition, households influence businesses and governments into actions during the cycle. In the recent boom, predatory lenders preyed on cognitive limitations and biases of subprime borrowers to sell them high cost mortgages that they would not be able to repay. Another contributing factor is that during boom times, household attention is not focused on financial regulation. This is when business influences the political process and laws are enacted to loosen market regulation. These changes may extend the boom period into bubble territory. During bust times, public outcry influences politicians to tighten business regulation, likely inhibiting the economic rebound. Thus, household behavior plays an important role in economic boom/bust cycles.

Liquidity Problems and Early Payment Default among Subprime Mortgages

Abstract We compare the twelve-month default probability among subprime borrowers differing only in the number of months before their first lump-sum property tax payment, after which time they may be exposed to reduced liquidity. We show that borrowers with an earlier property tax bill—within three months of origination—have 2% to 6% higher first-year default rates than borrowers facing their first property tax bill ten to twelve months after origination. Lump-sum property tax payments appear to produce a persistent state of low liquidity, the length of which raises the likelihood of default. These results are about one-third the effect size of a transition from 10% positive to 20% negative equity found in the literature. This paper provides causal evidence that liquidity constraints are important predictors of mortgage default.

Subprime Consumer Credit Demand: Evidence From a Lender's Pricing Experiment

Using a unique panel data set from a UK credit card company, we analyze the interest rate sensitivity of subprime credit card borrowers. In addition to all individual transactions and loan terms, we also have access to details of a randomized interest rate experiment conducted by the lender on the existing (inframarginal) loans. Access to such information by academic researchers is rare. The data and the experimental design provide us with a clean identification of heterogenous interest rate sensitivities across borrower types within the subprime population. We find that subprime credit card borrowers generally do not reduce their demand for credit when subject to increases in interest rates. However, we estimate a number of interesting responses that suggest that subprime borrowers are not a homogenous group. The paper also contributes to the literature by demonstrating the importance of isolating exogenous variation in interest rates. We show that estimating a standard credit demand equation with the non-experimental variation in the data leads to severely biased estimates. This is true even when conditioning on a rich set of controls and individual fixed effects.

The Political Economy of the Subprime Mortgage Credit Expansion

We examine how special interests, measured by campaign contributions from the mortgage industry, and constituent interests, measured by the share of subprime borrowers in a congressional district, may have influenced U.S. government policy toward the housing sector during the subprime mortgage credit expansion from 2002 to 2007. Beginning in 2002, mortgage industry campaign contributions increasingly targeted U.S. representatives from districts with a large fraction of subprime borrowers. During the expansion years, mortgage industry campaign contributions and the share of subprime borrowers in a congressional district increasingly predicted congressional voting behavior on housing related legislation. The evidence suggests that both subprime mortgage lenders and subprime mortgage borrowers influenced government policy toward housing finance during the subprime mortgage credit expansion.

The Subprime Virus: Theory and Evidence

We develop a theoretical model demonstrating the potential spillover effects associated with the introduction of risky assets. Specifcally, we examine the potential increase in mortgage default risk on prime mortgages that results from the introduction of subprime mortgages in a local area. The transmission mechanism is that the higher incidence of default by subprime borrowers leads to greater asset price volatility, which in turn impacts the default probability of prime mortgages in the same geographic area. Through numerical analysis, we demonstrate the impact of the origination of subprime mortgages to the risk of a portfolio of prime mortgages. Finally, we offer empirical support for our model by examining the spatial variation in MSA prime mortgage default rates correlated with the level of subprime mortgage activity.

Local authority residential mortgage credit: A source of non-market sub-prime homeloans for low-income households

As the volume of mortgage credit has risen in tandem with house price inflation, the sub-prime homeloan sector of this market has begun to expand in order to meet demand from those not serviced by the mainstream financial service providers. This article examines the role of local authorities in providing residential mortgages and assesses whether those who have traditionally borrowed from non-market (or public sector) lenders would be considered to be sub-prime borrowers by the private sector. It concludes that, in view of the relatively low average incomes of this cohort of borrowers, they represent a higher probability of homeloan default and as a consequence, would be subject to a higher cost of credit in the private sector. However, this paper highlights the favourable terms offered by local authorities and argues that their failure to price according to the risk profile of borrowers exposes the Exchequer to higher – and often unquantified – costs in pursuit of promoting home-ownership.

Household Behavior and Boom/Bust Cycles

I describe household behavior in boom and bust economic cycles with a particular focus on the recent financial crisis. The behaviors are motivated by cognitive limitations and psychological bias. In addition, household behavior exacerbates the boom/bust economic cycle. In boom times, households’ extrapolation bias and groupthink lead to chasing and extending asset bubbles (like tech stocks and real estate). Changing social norms foster the use of debt, which spurred the economy and eventually overburdened households. In bust times, the biases and fear lead to selling previously popular assets at low prices. The social norms regarding bankruptcy change to reduce the stigma of default. Households then repay debt and save more, which drags on an already slow economy. In addition, households influence businesses and governments into actions that also exacerbate the cycle. In boom times, predatory lenders preyed on cognitive limitations and biases of subprime borrowers to sell them high cost mortgages that they would not be able to repay. During the boom times, household attention is not focused on financial regulation. This is when business influences the political process and laws are enacted to loosen market regulation. These changes may extend the boom period into bubble territory. During bust times, public outcry influences politicians to tighten business regulation, likely inhibiting the economic rebound. Thus, economic boom/bust cycles are largely fed by household behavior.

Discussion

Discussion

The Leverage Cycle

The Leverage Cycle

Detecting and Explaining Systemic Risks of US Mortgage Banks - Evidence from the Subprime Crisis

In recent history, financial markets worldwide experienced severe turmoil due to the subprime crisis originating from the practice of US mortgage banks to securitise loans given especially to subprime borrowers. In the same crisis, several distressed banks were bailed out by states with even more banks receiving financial aids from governments. Using a unique data sample of 100 announcements of US mortgage banks between 2006 and 2009, this paper provides em-pirical evidence that isolated failures of US mortgage banks caused significant contagion effects in the US financial system. Conversely, especially the bailouts of Fannie Mae and Freddie Mac led to significant positive valuation effects at rival banks. In the cross-sectional analyses, contrary to previous studies in the literature on past financial crises, we find evi-dence for pure contagion effects following mortgage bank failures and rational valuation effects following bailouts. These results indicate that several of the failures of US mortgage banks during the subprime crisis caused irrational contagion in the US financial system thus justifying government intervention.

The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis*

We conduct a within-county analysis using detailed ZIP code—level data to document new findings regarding the origins of the biggest financial crisis since the Great Depression. The sharp increase in mortgage defaults in 2007 is significantly amplified in subprime ZIP codes, or ZIP codes with a disproportionately large share of subprime borrowers as of 1996. Prior to the default crisis, these subprime ZIP codes experience an unprecedented relative growth in mortgage credit. The expansion in mortgage credit from 2002 to 2005 to subprime ZIP codes occurs despite sharply declining relative (and in some cases absolute) income growth in these neighborhoods. In fact, 2002 to 2005 is the only period in the past eighteen years in which income and mortgage credit growth are negatively correlated. We show that the expansion in mortgage credit to subprime ZIP codes and its dissociation from income growth is closely correlated with the increase in securitization of subprime mortgages.

Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis

The credit crisis reflects the collapse of a tower of structured finance products based on subprime mortgage loans. These instruments-RMBSs, CDOs, SIVs, and CDSs-shifted the risk of mortgage lending, especially the default risk, from one party to another, until many lost sight of the real risks of the underlying loans. But when housing-price appreciation reversed, many subprime borrowers, having made only negligible down payments, owed more on their mortgages than their houses were worth. These borrowers exercised the put options in their mortgages, and defaults rose beyond the expectations priced into mortgage rates, RMBS yields, and CDS premiums. The downside risk of housing-market prices was shifted to lenders, and losses, magnified by vast leverage, spread up the tower of structured instruments to CDO investors and CDS sellers. The real risk of subprime mortgage investing became apparent, blowing up financial firms and, in turn, the economy.

Leverage and the Central Banker's Put

Among the many unusual aspects of the ongoing financial crisis is the unprecedented provision of backstop liquidity by central banks around the world. The Federal Reserve alone had committed $4,400 billion by mid-Novem ber 2008. The Fed funds rate is almost equal to zero. These are extraordinary numbers. This paper establishes a formal relationship between the recent monetary developments and the trends in private leverage and its structure. Over the last few years, some traditional insti tutions, for example broker-dealers, have relied more and more on markets (securitization, money market ) for their funding. Some banks have also increased their dependence on mar kets; the standard illustration is Northern Rock, a UK mortgage bank, which prior to its bailout relied on short-term wholesale markets for 75 percent of its funding. A second factor contributing to the reliance on wholesale markets is the overall shift from a bank-based system to a market-based one. The expanding so-called “shadow banking system” (conduits, hedge funds, investment banks, monolines ) has engaged in substantial transfor mation and, unlike commercial banks, could not avail itself of stable insured deposits. Mutual funds are under the threat of redemptions and may well face liquidity shortages as well. Adding subprime borrowers, who are heavily dependent on high housing prices and, for those with adjustable-rate mortgages (ARMs), on low short-term interest rates, and highly lever

The Subprime Crisis—Some Thoughts on a "Sustainable” and “Organic” Regulatory System

The Nation is now in the midst of one of the greatest financial crises in its history. Much of the blame for this condition is being placed on the bursting of the residential real estate bubble, which was fueled in large part by the reckless expansion of subprime mortgage lending. Those mortgages began defaulting in droves as the Federal Reserve Board drove up interest rates, causing massive losses at Bear Stearns, Lehman Brothers, Morgan Stanley, Citigroup, Wachovia, Washington Mutual, Countrywide Financial Group, American International Group and Merrill Lynch, to name a few. Those losses were shocking but paled in comparison to the failures of Lehman Brothers and Bear Stearns and the placing of Freddie Mac and Fannie Mae into conservatorship. Massive bailout packages for the financial service firms failed to restart lending, the country slipped into recession and unemployment soared. The subprime crisis had other ripple effects. The Dow Jones Industrial average was down 47 percent on February 19, 2009 from the high of 14,087 that was reached on October 1, 2007. This devastated retirement savings, college and other endowments, and every other investor in the market.On the other side of the equation were the subprime borrowers. They too were devastated by the subprime crisis as their adjustable rate mortgages (which had been originally issued at low teaser rates) reset at unaffordable levels. Foreclosures became an epidemic in many communities across the country, Florida being one of the worst centers for those sad events. Hispanics were also a particular target for subprime lenders. Hispanic homeownership in the United States grew by 47 percent between 2000 and 2007, compared to an overall homeownership increase of 8 percent. Tellingly, that growth was fueled by the fact that some 47 percent of mortgage loans to Hispanics were subprime and many of those loans are now being foreclosed. The African-American community has also been hard hit by the subprime crisis. Over one half of mortgage loans to African-Americans in 2006 were subprime, and they too are facing massive foreclosures. These problems have been blamed on flaws in the financial regulatory structure, and Congress has now begun the process of restructuring that regulation. This Article discusses the subprime mortgage market and the flaws in the financial system that led to the present crisis, and it will then provide some suggestions on regulatory reform.

Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis

The credit crisis reflects the collapse of a tower of structured finance products based on subprime mortgage loans. These instruments—RMBSs, CDOs, SIVs, and CDSs—shifted the risk of mortgage lending, especially the default risk, from one party to another, until many lost sight of the real risks of the underlying loans. But when housing-price appreciation reversed, many subprime borrowers, having made only negligible down payments, owed more on their mortgages than their houses were worth. These borrowers exercised the put options in their mortgages, and defaults rose beyond the expectations priced into mortgage rates, RMBS yields, and CDS premiums. The downside risk of housing-market prices was shifted to lenders, and losses, magnified by vast leverage, spread up the tower of structured instruments to CDO investors and CDS sellers. The real risk of subprime mortgage investing became apparent, blowing up financial firms and, in turn, the economy.