Starting in late 2006, mortgage delinquencies and foreclosures in the subprime mar- ket began to rise dramatically. By February 2008, one source counted 226 lenders having imploded since 2006.28
But delinquency in the subprime market may not necessarily be a sign of financial distress. Because of the riskier credit history of subprime borrowers, some may actually choose to substitute the higher interest rates and late penalties of the loan for other more traditional, but more expensive, short-term liquidity options, such as payday lending or check bouncing. Indeed, in contrast to the prime market in which delinquency rate for mortgage payments decreases between 30- day delinquency to 60-day and 90-day delinquency, for the subprime market, the rates are highest for 30-day (7.35 percent), decline for 60-day (2.02 percent), and increase again for 90-day (4.04 percent). Ninety-day delinquency rates can exceed 60-day delinquency rates if borrowers fall three months behind in their loans, then begin to repay without catching up to the current month’s payment. This is evidence that some subprime borrowers rationally choose to, in effect, take out short-term loans equal to one or two months of rent.29
Foreclosure itself, which may indicate financial distress, can be explained by two different, but conceptually related models. The first is thedistress model, wherein a borrower desires to repay the loan, but is unable to do so because of an income or expense shock such as job loss or ARM rate increase.30 Empirical support for this model is mixed.31The second is theoption model,in which foreclo- sure is driven by a change in the underlying asset. A mortgage essentially gives the borrower an option—she can pay the mortgage as contracted and retain the property or default and surrender the property. If the house falls in value, this creates incentives for borrowers to exercise their option to default and surrender the collateral. So, under this theory, foreclosure is essentially a rational response to the incentives created by the change in value of the asset.
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Determining which model has more explanatory power can be difficult because housing prices are inversely correlated with interest rates—as interest rates rise, housing prices fall. Nonetheless, empirical evidence seems to be on the side of the option theory.32 To wit, even though interest rates rise uniformly nationwide, the foreclosure rate is lower where residential real estate prices have appreciated more.33 One study found that in Massachusetts over an 18-year period, housing prices played the dominant role in generating foreclosures. They go on to point out that “subprime lending played a role but that role was creating a class of homeowners who were particularly sensitive to declining house price appreciation, rather than, as is commonly believed, by placing people in inherently problematic mortgages.”34
Another major factor driving foreclosure is the presence or absence of equity in the property. Loans with little or no down payment—such as those with high loan-to-value ratios (LTV)—offer unusually strong incentives to default if property values fall, and thus lower down payments predict higher rates of default.35One study finds that “the increases in the adjusted delinquency and foreclosure rates are almost exclusively caused by the worsening of performance of loans with a combined LTV of 80 percent or more.”36
Most outstanding mortgages remain traditional 30-year fixed-rate mortgages.
Interest rate fluctuations for these mortgages present a risk for new purchasers, but not for those with established mortgages. Similarly, unless a given homeowner intends to sell, short-term changes in property values are fundamentally irrelevant.
Traditional mortgage holders are more likely to have purchased a home as owner- occupied housing and to gain the amenities of home ownership. Homeowners also gain insurance against rent price volatility.37 These conditions are reversed in the subprime market, however. Because many subprime loans are ARMs, an increase in market interest rates will lead to an increase in rates not only for new borrowers but existing borrowers, creating the condition for a payment shock, which can lead to foreclosure. Also, in areas where there are a higher percentage of subprime loans, this increase in interest rates will have a more dramatic effect on pushing down house prices—the reverse of the effect of low interest rates in pushing up market prices. Higher rates and declining values feed off one another to exacerbate default rates. Keep in mind though, that although ARMs appears unreasonably risky when interest rates rise, they are also equally beneficial when they fall, and thus cannot be generalized as unreasonably risky.
Those who feel that subprime lending is nearly synonymous with predatory lending would like to see much stricter controls over the types of loans that can be offered and the methods that brokers and lenders use to advertise them.38But this position ignores the benefits of legitimate subprime lending. The broad presence of ARMs contributed to the crisis because of broad market conditions: stagnant and declining home values,39rising interest rates,40and slowing economic growth that was especially acute in some specific regions.41
CONCLUSION
Attempts to solve the problems of the subprime market must be tempered with the reality that it has likely boosted home ownership levels, and that strict an- tipredatory regulations can raise the costs of mortgage credit, thereby reducing le- gitimate lending. Current lending disclosure requirements are not ideal, and some
disclosure reform may go a long way toward helping borrowers make more in- formed decisions.
The subprime bust was not caused exclusively by unscrupulous lenders push- ing borrowers to sign unsuitable loans. Exuberant borrowers, lenders, and in- vestors combined with macroeconomic conditions to inflate housing prices and lure individuals to make what turned out to be bad bets. Without detailed knowl- edge of why certain loans went bad, a drastic reshaping of the mortgage mar- ket could hurt millions of homeowners afforded opportunities through expanded credit availability, foregoing a great deal of welfare gains to those individuals and their communities.
NOTES
1. See, for example, Center for Responsible Lending, CRL Issue Paper No. 14, “Subprime Lending: A Net Drain on Home Ownership” (2007), www.responsiblelending.org/
pdfs/Net-Drain-in-Home-Ownership.pdf.
2. Thomas P. Boehm and Alan Schlottmann, U.S. Department of Housing and Urban De- velopment, “Wealth Accumulation and Home Ownership: Evidence for Low-Income Households” (2004), www.huduser.org/Publications/pdf/WealthAccumulationAnd Homeownership.pdf.
3. Income or asset misrepresentation makes up 38 percent of fraud cases, and false prop- erty valuation accounts for 17 percent of fraud. Fannie Mae, Fannie Mae Mortgage Fraud Update 1 (2007), www.efanniemae.com/utility/legal/pdf/fraudupdate0507.pdf [hereinafter Fraud Update].
4. Preserving the American Dream: Predatory Lending and Home Foreclosures: Hearing before the Sen. Comm. on Banking, Housing and Urban Affairs, 110th Cong. 13 (2007).
(Statement of Douglas G. Duncan, chief economist, Mortgage Bankers Association.) 5. Christopher L. Cagan, “Mortgage Payment Reset: The Rumor and The Reality,” 6, Fig.
1 (First American Real Estate Solutions, February 8, 2006).
6. See James R. Barth et al., “Despite Foreclosures, Subprime Lending Increases Home- ownership,” Subprime Market Series, Milken Institute (2007).
7. As former Treasury Secretary Lawrence Summers recently stated the question, “We need to ask ourselves the question, and I don’t think the question has been put in a direct way and people have developed an answer; what is the optimal rate of foreclosures? How much are we prepared to accept?” Lawrence Summers, Remarks at the Panel Discussion on Recent Financial Market Disruptions: Implications for the Economy and American Families, Washington, DC: The Brookings Institution, September 26, 2007.
8. Souphala Chomsisengphet and Anthony Pennington-Cross, “The Evolution of the Sub- prime Mortgage Market,”Federal Reserve Bank of St. Louis Review32 (2006): 88.
9. Jeff Nielsen, “Looking at Subprime Clouds from Both Sides Now,” Navigant Consulting Presentation (February 28, 2008): 38 (citingInside Mortgage Finance).
10. See Vernon L. Smith, “The Clinton Housing Bubble,”Wall Street Journal,December 18, 2007, A20.
11. Kristopher Gerardi, Harvey S. Rosen, and Paul Willen, “Do Households Benefit from Financial Deregulation and Innovation? The Case of the Mortgage Market” (Federal Reserve Bank of Boston, Public Policy Discussion Papers 06-6, June 2006, 1).
12. Joseph E. Stiglitz and Andrew Weiss, “Credit Rationing in Markets with Imperfect Information,”American Economic Review71 (1981): 393.
SUBPRIMEMORTGAGES 187
13. Kathleen C. Engel and Patricia A. McCoy, “Turning a Blind Eye: Wall Street Finance of Predatory Lending”Fordham Law Review75 (2007): 107.
14. David Reiss, “Subprime Standardization: How Rating Agencies Allow Predatory Lend- ing to Flourish in the Secondary Mortgage Market,” 33Florida State University Law Review985, n. 95 (2006), quoting “Securitization: Asset-Backed and Mortgage-Backed Securities”§9.04, 9-21 (Ronald S. Borod, ed., 2003).
15. Michael Hudson, “Debt Bomb—Lending a Hand: How Wall Street Stoked the Mortgage Meltdown,”Wall Street Journal,June 27, 2007, A1.
16. Michael Hudson, “Debt Bomb—Lending a Hand: How Wall Street Stoked the Mortgage Meltdown,”Wall Street Journal,June 27, 2007, A1.
17. Souphala Chomsisengphet and Anthony Pennington-Cross, “The Evolution of the Sub- prime Mortgage Market,”Federal Reserve Bank of St. Louis Review32 (2006): 88.
18. Kathleen C. Engel and Patricia D. McCoy, “A Tale of Three Markets: The Law and Eco- nomics of Remedies for Predatory Lending,”Texas Law Review80 (2002): 1255, 1260 (sep- arating mortgage markets into prime, legitimate subprime, and predatory segments).
19. Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corp. and Office of Thrift Supervision, SR 01-4, Expanded Interagency Guidance for Subprime Lending Programs (2001), www.federal reserve.gov/boarddocs/srletters/2001/sr0104a1.pdf [hereinafter Guidance].
20. Morgan J. Rose, “Predatory Lending Practices and Subprime Foreclosures: Distinguish- ing Impacts by Loan Category,”Journal of Economics and Business13 (2008): 60. For exam- ple, while a three-year prepayment prohibition is associated with a higher probability of foreclosure for purchase money fixed-rate mortgages and refinance adjustable-rate mortgages, that same provision has no impact on increased foreclosures for refinance fixed-rate mortgages.
21. See Alan Greenspan and James Kennedy, “Sources and Uses of Equity Extracted from Homes” (Division of Research and Statistics and Monetary Affairs, Federal Reserve Board, Finance and Economics Discussion Series, Working Paper 2007-20); Margaret M.
McConnell, Richard W. Peach, and Alex Al-Haschimi, “After the Refinancing Boom:
Will Consumers Scale Back Their Spending?”Current Issues in Economics and Finance1 (2003): 9.
22. Keith S. Ernst, Center for Responsible Lending, “Borrowers Gain No Interest Rate Ben- efits from Prepayment Penalties on Subprime Mortgages” (2005): 5.
23. Joseph R. Mason and Joshua Rosner, “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage-Backed Securities and Collateralized Debt Obligations Market Disruptions” (May 2007): 54.
24. See “Economic Issues in Predatory Lending” (July 30, 2003): 12 (Office of the Comptroller of the Currency Working Paper).
25. Testimony of Anthony M. Yezer, U.S. House of Representatives, Committee on Financial Services, Subcommittee on Housing and Community Opportunity, Subcommittee on Financial Institutions and Consumer Credit (March 30, 2004).
26. Amy Crews Cutts and Robert A. Van Order, “On the Economics of Subprime Lending,”
Journal of Real Estate Finance and EconomicsSpecial Issue (2005): 175, Table 1.
27. Fred Phillips-Patrick, Eric Hirschorn, Jonathan Jones, and John LaRocca, “What About Subprime Mortgages?”Mortgage Market Trends(2000): 4.
28. The Mortgage Lender Implode-O-Meter home page, http://ml-implode.com/. Im- ploded, meaning gone bankrupt, halted major lending operations, or been sold at a fire sale price.
29. Amy Crews Cutts and Robert A. Van Order, “On the Economics of Subprime Lending,”
Journal of Real Estate Finance and EconomicsSpecial Issue 30 (2005): 173.
30. This can also be referred to as the “ability to pay” model, which “views home own- ership as a consumption good, and borrowers default when they can no longer make the payments.” William P. Alexander, Scott D. Grimshaw, Grant R. McQueen, and Barrett A. Slade, “Some Loans Are More Equal than Others: Third-Party Orig- inations and Defaults in the Subprime Mortgage Industry,”Real Estate Economics30 (2002): 667.
31. Compare Michelle A. Danis and Anthony Pennington-Cross, “The Delinquency of Subprime Mortgages,” Federal Reserve Bank of St. Louis (March 2005) (find- ing an inverse relationship between local unemployment and delinquencies) with Kristopher Gerardi, Adam Hale Shapiro, and Paul S. Willen, “Subprime Outcomes:
Risky Mortgages, Home Ownership Experiences, and Foreclosures,” Federal Reserve Bank of Boston (December 3, 2007) (finding a positive relationship between unem- ployment and delinquencies but a negative relationship between unemployment and foreclosure).
32. See Kerry D. Vandell, “How Ruthless Is Mortgage Default? A Review and Synthesis of the Evidence,”Journal of Housing Research6 (1995): 245; James B. Kau and Donald C. Keenan, “An Overview of the Option-Theoretic Pricing of Mortgages,”Journal of Housing Research6 (1995): 217; Patrick H. Hendershott and Robert Van Order, “Pricing Mortgages: An Interpretation of the Models and Results,”Journal of Financial Services Research1 (1987): 19.
33. Mark Dorns, Frederick Furlong, and John Krainer, “House Prices and Subprime Mort- gaged Delinquencies,” FRBSF Economic Letter, November 2007-14 (June 8, 2007); Ellen Schloemer, Wei Li, Keith Ernst, and Kathleen Keest, “Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners,”Center for Responsible Lending (December 2006): 13.
34. Kristopher Gerardi, Adam Hale Shapiro, and Paul S. Willen, “Subprime Outcomes:
Risky Mortgages, Home Ownership Experiences, and Foreclosures,” Federal Reserve Bank of Boston (December 3, 2007): 1. More particularly, those who suffer a drop in value of greater than 20 percent have a 0.70 percent probability of defaulting, between negative 20 percent and zero have a 0.30 percent probability of defaulting, those who have an increase in value of zero to 20 percent have a 0.10 percent probability of defaulting, and those whose homes appreciate in value by more than 20 percent have only a 0.05 percent probability of defaulting.
35. Joseph R. Mason and Joshua Rosner, “How Resilient Are Mortgage-Backed Securities to Collateralized Debt Obligation Market Disruptions?” Hudson Institute, Washington, DC (February 15, 2007).
36. See Yuliya Demyanyk and Otto Van Hemert, supra note 94, at 4.
37. Todd Sinai and Nicholas S. Souleles, “Owner-Occupied Housing as a Hedge Against Rent Risk,”Quarterly Journal of Economics120 (2005): 763.
38. Catherine Rampell, “Elizabeth Warren on Consumer Financial Protection,” Economix blog, June 17, 2009, http://economix.blogs.nytimes.com/2009/06/17/elizabeth -warren-on-consumer-financial-protection/.
39. Nationwide, annualized house price appreciation dropped from 11.88 percent in the fourth quarter of 2005 to 1.81 percent in the first quarter of 2007. See Press Release, Office of Federal Housing Enterprise Oversight, “U.S. House Price Appreciation Rate Remains Slow, but Positive,” May 31, 2007, on file with author.
SUBPRIMEMORTGAGES 189
40. The federal funds rate has risen from 1 percent in June 2004 to a plateau of 5.25 percent beginning in June 2006. The Federal Reserve Board, Open Market Operations (2008), www.federalreserve.gov/FOMC/fundsrate.htm.
41. In the four quarters between the third quarter of 2006 and the second quarter of 2007, GDP grew at rates of 1.1 percent, 2.1 percent, 0.6 percent, and 3.4 percent. Data from the Bureau of Economic Analysis.
ABOUT THE AUTHORS
Todd J. Zywickiis George Mason University Foundation professor of law, a se- nior scholar at the Mercatus Center, and co-editor of theSupreme Court Economic Review.From 2003 to 2004, Professor Zywicki served as the director of the Office of Policy Planning at the Federal Trade Commission. He is a member of the board of directors and governing board of the Financial Services Research Program. Profes- sor Zywicki clerked for Judge Jerry E. Smith of the U.S. Court of Appeals for the Fifth Circuit, and practiced law in Atlanta. He received his law degree from the University of Virginia, where he was a John M. Olin Scholar in law and economics, a master’s degree in economics from Clemson University, and his undergraduate degree cum laude with high honors in his major from Dartmouth College. He has lectured and consulted with government officials around the world, including Ice- land, Italy, Japan, and Guatemala. Professor Zywicki has testifed before Congress several times on issues of bankruptcy law and consumer credit and is a frequent commentator on legal and business issues in the print and broadcast media. In 2006, Professor Zywicki served as a member of the United States Department of Justice Study Group on “Identifying Fraud, Abuse and Errors in the United States Bankruptcy System.”
Satya Thallam is director of the Financial Markets Working Group at the Mercatus Center at George Mason University, an interdisciplinary group of 16 scholars working collaboratively to understand financial crises, conduct origi- nal research, and advise policy makers. He was previously the Hernando de Soto Fellow and author of the 2008 International Property Rights Index. He completed his graduate studies in economics at Emory University and received his B.A. (cum laude) in economics from Arizona State University. He has authored numerous op-ed pieces that have appeared in publications such as theArizona Republicand theOrange County Register.He is a senior editor of the financial regulation journal Lombard Street.
CHAPTER 25
Rating Agencies
Facilitators of Predatory Lending in the Subprime Market
DAVID J. REISS
Professor of Law at Brooklyn Law School∗
As the credit crisis unfolds, credit rating agencies have been properly identi- fied as playing a central role in causing the crisis and misleading investors.
What has been forgotten in this acrimonious environment is that in their quest to increase the market for their services, rating agencies also took positions that were particularly bad for many homeowners.
Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings (collectively, the “Big Three”) utterly dominate the credit rating market, particularly that for mortgage-backed securities. The Big Three provide ratings for pools of mortgages that are converted to securities and sold to investors around the world, a process known assecuritization. The Big Three claim that they are merely editorializing about the credit quality of the securities that they rate and do not take an active role in the structuring of the securities. For their labors, the Big Three are compensated by fees from the issuers of securities that solicit ratings from them.
Certain rating agencies, including the Big Three, are what are known as Na- tional Recognized Statistical Rating Organizations (NRSROs). The Securities and Exchange Commission (SEC) first granted NRSRO status in 1975. NRSRO status initially referred to those rating agencies whose ratings could be used in imple- menting the net capital requirements (the minimum ratio of indebtedness to liquid assets) for broker-dealers, a very modest incorporation of ratings into financial regulation.
As NRSROs, the Big Three have since been granted a privileged status by numerous financial services regulators. This privileged status results from the incorporation of the Big Three’s ratings throughout a vast web of government
∗Rating Agencies and Reputational Risk,“Rating Agencies and Reputational Risk,” 4 Mary- land J. Bus. & Tech. L. 295 (2009), http://ssrn.com/abstract=1358316 [hereinafter Reiss, Reputational Risk];Regulation of Subprime and Predatory Lending,International Encyclopedia of Housing and Home (forthcoming 2010), http://ssrn.com/abstract=1371728. Thanks to Philip Tucker and Jason Gang for excellent research assistance.
191 Copyright © 2010 John Wiley & Sons, Inc.
192 Borrowers
regulation of private companies—requiring or encouraging market players such as broker-dealers, banks, money market funds, insurance companies, and pension funds to purchase financial instruments endorsed by an NRSRO.
As a result of their regulatory privilege, the Big Three operate as an oligopoly.
The lack of a rating from at least one of the Big Three, which effectively grant reg- ulatory licenses to institutions that wish to issue securities, is the financial equiv- alent of a death sentence for a residential mortgage-backed securities (RMBS) offering. Thus, the Big Three’s NRSRO status makes them gatekeepers to other private financial entities attempting to access the financial markets. While the Big Three thereby bestow significant regulatory benefits upon issuers of securi- ties, they themselves have not been subject to significant regulation of their own activities.
The most vehement criticism of the Big Three is that they do not provide ac- curate and valuable information to the markets. The Big Three also faced popular criticism for failing to warn of dramatic failures such as that of Enron. Lost within the ongoing debate over the flaws of the Big Three is that they have also taken anticonsumer positions that were aligned with the interests of their own industry and the securitization industry as a whole. In particular, the Big Three took posi- tions against a variety of consumer protection statutes that were intended to assist subprime borrowers and curb predatory lending because such statutes might slow the growth of the subprime RMBS market, thereby slowing the growth of the Big Three themselves.