Subprime bust has its positives

Mortgage Banking, Jan, 2008 by Howard Schneider

Former Federal Reserve Governor Edward Gramlich saw subprime lending following a boom-and-bust path that is common in American economic history. Yet he predicted that this lending experiment would have positive aftereffects, although the work practices of mortgage brokers most likely will change as events unfold.

Gramlich recently authored a book on subprime lending, and wrote a paper for the Fed's August annual conference in Jackson Hole, Wyoming. Unfortunately, he wasn't well enough to deliver the paper personally, and passed away five days later of leukemia.

In his paper, Booms and Busts, the Case of Subprime Mortgages, Gramlich noted that productivity growth comes in fits and starts. The dot-com boom and bust had been preceded by other times of rapid growth in areas ranging from railroads and mining to financial services and manufacturing. "Each of these cases features initial discoveries or breakthroughs, widespread adoption, widespread investment and then a collapse where prices cannot keep up and many investors lose a lot of money," wrote Gramlich.

"When the dust clears there is financial carnage, many investors learning to be more careful next time, but there are often the fruits of the boom still around to benefit productivity. The canals and railroads are still there and function, the minerals are discovered and in use, the financing innovations stay, and we still have the Internet and all its capabilities," he added.

Rapid growth

In his paper, Gramlich stated, "from essentially zero in 1993, sub-prime mortgage originations grew to $625 billion by 2005--one-fifth of total mortgage originations in that year, a whopping 26 percent annual rate of increase over the whole period."

He added, "12 million new homeowners were created over this period, largely first-time homebuyers, largely racial and ethnic minorities, largely lower-income households. America's overall homeownership rate rose from 64 [percent] to 69 percent, putting the United States in the top tier of countries in the world in terms of ownership rates."

Several factors made subprime lending growth possible, according to Gramlich. Relaxed usury laws allowed lenders to raise rates on riskier mortgages. Automated underwriting, securitization and the Community Reinvestment Act [CRA] also encouraged subprime lending. But "unlike the conservative, staid, prime mortgage market featuring fixed-rate, long-term mortgages made under tight supervisory conditions, the sub-prime market was the Wild West," Gramlich added. "Over half the mortgage loans were made by independent lenders without any federal supervision."

Many of these were adjustable-rate loans that "borrowers seem to understand very poorly," Gramlich wrote. Lenders locked homeowners into these deals with prepayment penalties, and also didn't escrow for taxes and insurance.

"The predictable result was carnage," Gramlich wrote. The results include dozens of lender bankruptcies, "and many urban neighborhoods have been devastated by widespread foreclosures," according to Gramlich's paper.

Yet Gramlich believed "the subprime mortgage market was a valid innovation," noting that many of the new homeowners "would have been denied mortgage credit in the early 1990s." He estimated that "about 88 percent of these new homeowners are making their payments and retaining their houses."

More oversight

Citing 2005 data from the Home Mortgage Disclosure Act (HMDA), Gramlich explained in his paper that roughly half of all subprime mortgages were originated by federally regulated banks and thrifts or their affiliates. And the remaining 50 percent of subprime originations came from "state-chartered but not federally supervised independent mortgage companies," Gramlich wrote.

"Typically the states bring a lot less resources to the supervisory process," he added, "and most reports of abusive or predatory lending do emanate from this sector. This is in contrast to the prime mortgage market, where virtually all loans are made by federally supervised banks or thrifts, or affiliates, with only a trivial share made by independent mortgage companies."

Current practices create "a giant hole in the supervisory safety net," Gramlich concluded. "In the prime market where we need supervision less, we have lots of it. In the subprime market, where we badly need supervision, a majority of loans are made with very little supervision. It is like a city with a murder law but no cops on the beat."

Unsupervised subprime lending will "jeopardize the twin American dreams of owning a home and building wealth," Gramlich said in a 2002 speech, according to The New York Times. He added that any regulations put on subprime lenders must apply to all of them--otherwise, lenders that can relax standards will do so to gain more business.

Gramlich also advocated increased counseling from nonprofit housing groups. "The most risky loan products [are] sold to the least-sophisticated borrowers," he explained. Bloomberg News adds, "Gramlich noted that, when called upon, these groups have been successful in averting some two-thirds of potential foreclosures."