Sub-prime mortgage lending has been in the news for several months. Just recently, the federal financial regulatory agencies issued a statement on sub-prime mortgage lending. The statement calls for lending institutions to analyze a sub-prime borrower's ability to repay an adjustable rate mortgage at the fully indexed rate, assuming a fully amortizing repayment schedule. The statement also calls for clear communications with consumers.
What is the reason for the statement and why is sub-prime lending in the news recently?
First, sub-prime mortgages make up a larger share of outstanding mortgages than ever before. In 1998, fewer than 600,000 sub-prime mortgages were out-standing, representing less than 2.5 percent of all mortgages. Just eight years later, 5.8 million sub-prime mortgages were outstanding, representing more than 13.5 percent of all mortgages. The peak year for sub-prime mortgage originations was 2004.
These sub-prime mortgages are now showing a significant increase in delinquencies and foreclosures. The amount of all sub-prime mortgages nationwide that were at least 30 days delinquent reached 13.3 percent during the fourth quarter of 2006. All indications are that foreclosure rates will move higher in 2007.
A major reason for the rapid deterioration of average sub-prime mortgage quality is that the majority of these loans had either adjustable rates when originated or low initial rates (called "teaser" rates) that are now converting to adjustable rates after two or three years. The combination of rising short-term interest rates during 2004, 2005 and 2006—and the contractual switch from initial low teaser rates to fully indexed rates—means that many mortgage holders are now facing significant payment shock.
The payment shock has been further complicated by a slowdown in housing price appreciation in many parts of the country and weak economic conditions in areas such as the upper Midwest, with its concentration of auto-related and other manufacturing industries.
The years 2007 and 2008 promise to be challenging both for lenders and borrowers who chose adjustable rate sub-prime mortgages. Some borrowers will be capable of refinancing into other mortgage products. Other borrowers will not and will need to work with their lenders to avoid foreclosure wherever possible. Congress has also promised legislative action. In the end, the lesson learned will likely be one that bankers have learned many times over: Strong underwriting practices and careful consumer disclosure are the best tools to avoid long-term issues.