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Federal Reserve Bank of St. Louis and Poole, William, 1937 June 19- "Reputation and the Non-prime Mortgage Market." St. Louis Association of Real Estate Professionals, St. Louis, Missouri, July 20, 2007, https://fraser.stlouisfed.org/title/485/item/18810, accessed on July 16, 2025.

Title: Reputation and the Non-prime Mortgage Market : St. Louis Association of Real Estate Professionals, St. Louis, Missouri

Date: July 20, 2007
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image-container-0 Reputation and the Non-Prime Mortgage Market St. Louis Association of Real Estate Professionals St. Louis, Missouri July 20, 2007 M y topic this morning is the non- prime mortgage market, which has been in the news on almost a daily basis. Non-prime mortgages are the common denominator in such diverse recent developments as rising household fore- closure rates and collapsing hedge funds. You also may have read some of the news coverage of Federal Reserve Chairman Ben Bernanke’s testimony on this topic before Congress earlier this week (Bernanke, 2007a). Developments in the non-prime mortgage market matter to the Federal Reserve for three main reasons. First, the non-prime mortgage market—with 2006 originations of about one trillion dollars 1 —clearly is large enough to affect aggregate homebuilding activity and consumer spending. Second, the Fed also supervises some banks and most financially oriented holding com- panies; consistent with those responsibilities, the Fed is monitoring the performance of non-prime mortgage loans carefully for signs of further credit deterioration. Congress has granted the Federal Reserve the authority to define unfair and decep- tive acts and practices under several important federal consumer-protection statutes. We take this responsibility seriously, and we are gathering information now to determine what else we should do to modify disclosure and other regulations. Most of the news, and most of the problems, relate to the highest risk part of the non-prime mortgage market—the subprime market. There have also been some problems in the so-called “Alt-A” market, which lies between prime and subprime. What I am calling the non-prime market covers subprime and Alt-A. There are, of course, a variety of non-prime markets, in auto loans and elsewhere. To streamline the exposition, I will drop the modifier “mortgage,” and you can assume I am discussing the mortgage market unless I make specific mention of some other market. Some of the problems we’re seeing in the non-prime market may have been inevitable given the breakneck innovation and growth of recent years, followed by a significant cooling of housing- market activity. Yet it is important that we learn the correct lessons from these problems. In a future housing-market slowdown, we want to avoid repetition of recent problems. We also want to preserve appropriate access to credit by those with impaired credit standing. The subprime market in particular is an immature market—a baby market in age, though not in size—and we want to remember the adage about not discarding the baby with the bathwater. My premise today is that a lasting improve- ment in the functioning of the non-prime market is most likely if we correct the fundamental prob- lems that seem to be causing the greatest difficul- ties, rather than attacking mere symptoms of the problem. To preview my conclusion briefly, I believe the fundamental problems in the non- prime mortgage market amenable to improvement stem from inadequate incentives among some of the parties operating in the market to create and maintain strong reputations for quality and fair- dealing. A solid reputation is a valuable asset for the individual firm, for the economy and society 1 Non-prime mortgage originations during 2006 consisted of approximately $600 billion of subprime and about $400 billion of Alt-A mortgages. These terms are defined below. 1
image-container-1 as a whole. This point is not a new one. “My word is my bond” has been the motto of the London Stock Exchange since 1801. Every long-lived business depends on trust in the marketplace. The firm benefits from a durable business franchise, which is why build- ing trust is important to the firm. The economy is more efficient because market disciplines will tend to reduce shortsighted, opportunistic and ultimately wasteful business practices. A better- functioning market will require lenders who are better informed about borrowers’ capacity to serv- ice debt and borrowers who are better informed about the commitments they are making. When lenders and borrowers alike understand their commitments and risks, sub-optimal outcomes such as mortgage write-downs and foreclosures are less likely. Society benefits from a more effi- cient use of its scarce resources. I’ll begin by describing the current non-prime market and providing some basic background on the sector. Next comes a discussion of the role of mortgage brokers and realtors and the reputations they establish. I’ll finish with a few comments on the Federal Reserve’s oversight role in the non- prime market, including a summary of what ini- tiatives and actions we’re undertaking. Before proceeding, I want to emphasize that the views I express here are mine and do not necessarily reflect official positions of the Federal Reserve System. I thank my colleagues at the Federal Reserve Bank of St. Louis for their com- ments. William R. Emmons, senior economist in the Banking Supervision and Regulation Division, and Rajdeep Sengupta, economist in the Research Division, provided special assistance. I retain full responsibility for errors. THE NON-PRIME MORTGAGE MARKET: SUBPRIME AND ALT-A SECTORS Market convention is evolving toward a dif- ferentiation between prime and non-prime mort- gages, and further to subprime and Alt-A sectors of the non-prime market. Analysts face problems in gathering accurate information about the non- prime mortgage markets. I won’t dwell on those here, but my text, which is available on the St. Louis Fed web site, describes these difficulties in greater detail. According to the federal banking and thrift regulatory agencies, subprime mortgages are those made to borrowers who display, among other characteristics, (i) a previous record of delinquency, foreclosure or bankruptcy, (ii) a low credit score, and/or (iii) a ratio of debt service to income of 50 percent or greater (Office of the Comptroller of the Currency, et al., 2007). An Alt-A mortgage—short for “alternative-A” and also known as “A minus”—is one made to a bor- rower who might be of prime credit quality but who does not qualify for a prime loan because there is something missing or irregular in the loan application. The borrower’s credit record may be incomplete or slightly impaired, or the borrower may be purchasing the property as an investment rather than to live in it (Chomsisengphet and Pennington-Cross, 2006). An application file is deemed incomplete when it is missing certain information, as, for example, when the borrower is unwilling or unable to document income or assets to the lender’s satisfaction. An irregular application might be one where the borrower does not have a large enough downpayment to satisfy the lender’s standard underwriting crite- ria for prime credit. Alternatively, the borrower’s credit history may be short, perhaps because the borrower is young. Thus, the non-prime mortgage sector consists of mortgages that entail a borrow- ing household with a B, C or D credit grade, a non-standard or incomplete loan application or credit history, or all of these. Non-prime mortgages carry interest rates notably higher than those on prime mortgages. For a non-prime fixed-rate mortgage (FRM), the spread over a prime FRM could be several per- centage points, depending on the borrower and the loan. For a non-prime adjustable-rate mortgage (ARM), the initial rate could be one-half to one percentage point above a comparable prime ARM initial interest rate, while the fully implemented margin of a non-prime ARM could be two or FINANCIAL MARKETS 2
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Date: July 20, 2007
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