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Reputation and the Non-Prime Mortgage Market

St. Louis Association of Real Estate ProfessionalsSt. Louis, Missouri

July 20, 2007

subprime. What I am calling the non-prime marketcovers subprime and Alt-A. There are, of course,a variety of non-prime markets, in auto loans andelsewhere. To streamline the exposition, I willdrop the modifier “mortgage,” and you can assumeI am discussing the mortgage market unless I makespecific mention of some other market.

Some of the problems we’re seeing in thenon-prime market may have been inevitable giventhe breakneck innovation and growth of recentyears, followed by a significant cooling of housing-market activity. Yet it is important that we learnthe correct lessons from these problems. In a futurehousing-market slowdown, we want to avoidrepetition of recent problems. We also want topreserve appropriate access to credit by thosewith impaired credit standing. The subprimemarket in particular is an immature market—ababy market in age, though not in size—and wewant to remember the adage about not discardingthe baby with the bathwater.

My premise today is that a lasting improve-ment in the functioning of the non-prime marketis most likely if we correct the fundamental prob-lems that seem to be causing the greatest difficul-ties, rather than attacking mere symptoms of theproblem. To preview my conclusion briefly, Ibelieve the fundamental problems in the non-prime mortgage market amenable to improvementstem from inadequate incentives among some ofthe parties operating in the market to create andmaintain strong reputations for quality and fair-dealing. A solid reputation is a valuable asset forthe individual firm, for the economy and society

M y topic this morning is the non-prime mortgage market, whichhas been in the news on almost adaily basis. Non-prime mortgages

are the common denominator in such diverserecent developments as rising household fore-closure rates and collapsing hedge funds. Youalso may have read some of the news coverageof Federal Reserve Chairman Ben Bernanke’stestimony on this topic before Congress earlierthis week (Bernanke, 2007a).

Developments in the non-prime mortgagemarket matter to the Federal Reserve for threemain reasons. First, the non-prime mortgagemarket—with 2006 originations of about onetrillion dollars1—clearly is large enough to affectaggregate homebuilding activity and consumerspending. Second, the Fed also supervises somebanks and most financially oriented holding com-panies; consistent with those responsibilities, theFed is monitoring the performance of non-primemortgage loans carefully for signs of further creditdeterioration. Congress has granted the FederalReserve the authority to define unfair and decep-tive acts and practices under several importantfederal consumer-protection statutes. We take thisresponsibility seriously, and we are gatheringinformation now to determine what else we shoulddo to modify disclosure and other regulations.

Most of the news, and most of the problems,relate to the highest risk part of the non-primemortgage market—the subprime market. Therehave also been some problems in the so-called“Alt-A” market, which lies between prime and

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.

as a whole. This point is not a new one. “My wordis my bond” has been the motto of the LondonStock Exchange since 1801.

Every long-lived business depends on trustin the marketplace. The firm benefits from adurable business franchise, which is why build-ing trust is important to the firm. The economyis more efficient because market disciplines willtend to reduce shortsighted, opportunistic andultimately wasteful business practices. A better-functioning market will require lenders who arebetter informed about borrowers’ capacity to serv-ice debt and borrowers who are better informedabout the commitments they are making. Whenlenders and borrowers alike understand theircommitments and risks, sub-optimal outcomessuch as mortgage write-downs and foreclosuresare less likely. Society benefits from a more effi-cient use of its scarce resources.

I’ll begin by describing the current non-primemarket and providing some basic background onthe sector. Next comes a discussion of the role ofmortgage brokers and realtors and the reputationsthey establish. I’ll finish with a few comments onthe 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 thatthe views I express here are mine and do notnecessarily reflect official positions of the FederalReserve System. I thank my colleagues at theFederal Reserve Bank of St. Louis for their com-ments. William R. Emmons, senior economist inthe Banking Supervision and Regulation Division,and Rajdeep Sengupta, economist in the ResearchDivision, provided special assistance. I retainfull responsibility for errors.

THE NON-PRIME MORTGAGEMARKET: SUBPRIME AND ALT-ASECTORS

Market convention is evolving toward a dif-ferentiation between prime and non-prime mort-gages, and further to subprime and Alt-A sectorsof the non-prime market. Analysts face problems

in gathering accurate information about the non-prime mortgage markets. I won’t dwell on thosehere, but my text, which is available on the St.Louis Fed web site, describes these difficultiesin greater detail.

According to the federal banking and thriftregulatory agencies, subprime mortgages arethose made to borrowers who display, amongother characteristics, (i) a previous record ofdelinquency, foreclosure or bankruptcy, (ii) a lowcredit score, and/or (iii) a ratio of debt service toincome of 50 percent or greater (Office of theComptroller of the Currency, et al., 2007). AnAlt-A mortgage—short for “alternative-A” andalso known as “A minus”—is one made to a bor-rower who might be of prime credit quality butwho does not qualify for a prime loan becausethere is something missing or irregular in the loanapplication. The borrower’s credit record may beincomplete or slightly impaired, or the borrowermay be purchasing the property as an investmentrather than to live in it (Chomsisengphet andPennington-Cross, 2006). An application file isdeemed incomplete when it is missing certaininformation, as, for example, when the borroweris unwilling or unable to document income orassets to the lender’s satisfaction. An irregularapplication might be one where the borrowerdoes not have a large enough downpayment tosatisfy the lender’s standard underwriting crite-ria for prime credit. Alternatively, the borrower’scredit history may be short, perhaps because theborrower is young. Thus, the non-prime mortgagesector consists of mortgages that entail a borrow-ing household with a B, C or D credit grade, anon-standard or incomplete loan application orcredit history, or all of these.

Non-prime mortgages carry interest ratesnotably higher than those on prime mortgages.For a non-prime fixed-rate mortgage (FRM), thespread over a prime FRM could be several per-centage points, depending on the borrower andthe loan. For a non-prime adjustable-rate mortgage(ARM), the initial rate could be one-half to onepercentage point above a comparable prime ARMinitial interest rate, while the fully implementedmargin of a non-prime ARM could be two or

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three percentage points higher than the marginon a prime ARM, itself likely to be as much asthree percentage points.2

Higher rates are one, but not the only, impor-tant distinguishing characteristic of non-primeloans. High rates are necessary for lenders to makean adequate return on investment when facingrelatively high underwriting costs and prospec-tively high delinquency and default rates. Charg-ing high rates, therefore, reflects cost- andrisk-based pricing and can be perfectly consistentwith competitive markets. It is important to under-stand that high rates on non-prime mortgages donot, per se, indicate either a lack of competitionor predatory behavior by lenders.

There are several other notable differencesbetween prime and non-prime loans. Prime mort-gages are more likely to include a fixed interestrate for the life of the loan as well as automaticfunding of, and disbursement from, an escrowaccount used to pay the homeowner’s taxes andinsurance obligations. During most periods, alarger fraction of prime mortgage loans are forhome purchase than for refinancing, in contrastto the non-prime sector, where refinancing is amore common loan purpose. Non-prime loanstypically charge higher up-front fees, are morelikely to include prepayment penalties, mayaccept limited or no documentation of the bor-rower’s income or assets, and may be used byinvestors rather than by owner-occupiers. Someof these practices in the non-prime market havebeen responsible for high default rates and it is nodoubt true that lenders are much more cautioustoday than a few years ago in accepting limiteddocumentation.

Another distinguishing feature of the non-prime sector is product innovation. In contrastto the traditional 30-year, fixed-rate, amortizingmortgage that dominates the prime sector, the sub-

prime and Alt-A sectors include a wide varietyof adjustable and hybrid interest-rate structures,together with a range of principal-amortizationoptions.3 Of particular note is the recent popular-ity of so-called “negatively amortizing” mortgages,such as the “pay-option ARM.” The federal bank-ing and thrift supervisory agencies issued guid-ance in 2006 that described these complexmortgages and provided direction to supervisorsand lenders on how best to offer and managethese loans (Office of the Comptroller of theCurrency, et al., 2006).

EVOLUTION OF THE NON-PRIMEMORTGAGE MARKET

In the prime mortgage market, securitizationbegan around 1970. Packaging mortgages intosecurities was an important innovation, as it per-mitted development of a secondary market inmortgages and allowed banks and other mortgageoriginators to control portfolio risk by sellingmortgages into the capital market. In the non-prime market, securitization began in earnest onlyin the mid-1990s. In part because securitizationexpertise and distribution networks existedalready for prime mortgages, the growth of non-prime securitization has been even more rapidthan early developments in the prime sector. Ittook about 35 years for three quarters of primemortgage originations to be securitized, but acomparable share may be reached in half thetime in the non-prime market (Chomsisengphetand Pennington-Cross, 2006).

Along with an increased volume of credit-related information about households andimprovements in credit-risk analysis by lenders,securitization probably is the key factor that sup-ported the burgeoning growth of the non-prime


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2 An ARM margin is the amount by which the borrower’s interest rate exceeds the index rate, such as one-year LIBOR.

3 A so-called hybrid mortgage commences with a fixed rate for a few years and then converts to an adjustable rate for the duration of the mortgageterm. For example, a 2/28 hybrid has a fixed rate for two years, after which the rate begins to adjust every six or 12 months with reference toan index rate, such as six-month LIBOR or the one-year Treasury yield. A subprime 2/28 mortgage might carry a 550 basis-point margin, whichmeans that, after the initial two-year “teaser” rate has expired, the fully indexed mortgage rate will be the index rate plus 550 basis points.There may be contractual limits on how quickly the mortgage rate may adjust toward the fully indexed rate, as well as limits on how muchthe mortgage rate may change during the life of the loan.

mortgage market since the mid-1990s. By openinglocal non-prime mortgage markets to nationaland global capital markets, the flow of capital tothe sector surged as never before. Rising houseprices also played an important role, as borrowersand lenders came to expect healthy gains in theequity that borrowers had in their houses, sup-porting more aggressive loan-to-value ratios inunderwriting both first- and second-lien mort-gages. Finally, household incomes have grownrelatively rapidly in comparison to the cost ofborrowing—especially during the early part ofthis decade, when economic recovery precededthe gradual upward movement of market interestrates.

One aspect of recent developments was oddand has turned out to be the source of much dif-ficulty in the non-prime market. The steep yieldcurve during much of the 2002-04 period reflectedinvestor expectations that short-term interest rateswould be rising, which they in fact did. Yet, manymortgage-market participants apparently did notanticipate this increase. Of course, I would notexpect average homeowners to be able to readthe yield curve, but I find it odd that apparentlysophisticated investors in non-prime mortgage-backed securities now claim surprise that manynon-prime ARM borrowers are facing paymentshock because of the increase in short-term interestrates over the past few years. Apparently drivenby the prospects of high fee income and substan-tial spreads on non-prime ARMs, mortgage origi-nators persuaded many relatively unsophisticatedborrowers to take out these mortgages; then,investors willingly purchased them when theywere securitized. Many of these mortgages arenow in default, some of the lenders are bankrupt,and the mortgage-backed securities are trading atdeep discounts to face value.

It is important to emphasize that what is oddis not that there was a risk of rising short-terminterest rates, as there always is, but that the mar-ket clearly expected an increase, as indicated bythe shape of the yield curve. This expectation, inturn, was encouraged by the Fed’s Open MarketCommittee. The policy statement issued at theconclusion of the FOMC meeting of May 4, 2004,

said that “the Committee believes that policyaccommodation can be removed at a pace that islikely to be measured.” A similar phrase appearedin subsequent FOMC policy statements untilDecember 2005, when the language was changedslightly to “the Committee judges that some furthermeasured policy firming is likely to be needed.”At its next meeting, in January 2006, the languagechanged from “is likely to be needed” to “maybe needed,” and somewhat similar languageremained in the policy statement through theFOMC meeting in January 2007.

Given these widely held expectations of risinginterest rates, it is difficult to avoid the judgmentthat these ARM loans were poorly underwrittenat the outset. It was imprudent for mortgage bro-kers and lenders to approve borrowers who likelycould not service the loans when rates rose, andit is surprising to me that sophisticated capital-market investors willingly purchased securitiesbacked by such poorly underwritten mortgages.

As a number of observers have emphasized,rapid growth of the non-prime sector has broad-ened access to mortgage credit in recent years.The Federal Reserve’s Survey of ConsumerFinances provides data on the percentage of fam-ilies that had some mortgage debt on a primaryresidence at three-year intervals between 1989and 2004. Between 1989 and 1995, there was littlechange in the fraction of families that had a firstmortgage in any income group, except for theincome group representing the 20 percent of fam-ilies with the lowest incomes, where the fractionof families with mortgages rose from 7.6 percentto 10.4 percent. Gains for these families continuedafter 1995, with the fraction of those with mort-gages rising to 15.9 percent in 2004. Thus, in aperiod of only 15 years, from 1989 to 2004, thepercentage of families in the lowest income quin-tile that had mortgages more than doubled.

Between 1995 and 2004, the fraction of fami-lies with a mortgage on a primary residenceincreased notably in all income groups. Thelargest increases were among families below thehighest income quintile, suggesting that accessto mortgage credit may have increased most forfamilies that were in the middle and lower parts

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of the income distribution. The middle-incomequintile—those families with incomes betweenthe 40th and the 60th percentiles of the incomedistribution—is particularly striking. After essen-tially no increase in the incidence of first mort-gages between 1989 and 1995, the fractionincreased 13.5 percentage points between 1995and 2004. This period coincides with the mostrapid growth of the non-prime mortgage market,and it is likely that families in lower and middle-income groups were among those receiving non-prime mortgages. Table 1 provides more completedata.

The data just discussed cover all mortgages.Comprehensive, long-term data are not readilyavailable on the share of the non-prime mortgagesector in the total market or its composition. Onereason for the lack of good data on the non-primemarket is that the terms in common use today—subprime and Alt-A, or borrower grades B, C andD—are not defined precisely or consistentlyacross lenders or across time. Another reason forthe lack of a good historical database is that whatwe now call the non-prime sector was quite smalluntil recently, and thus was easily overlooked.Yet another important reason for the paucity ofgood data is that these types of mortgages were,until recently, not even offered by depositoryinstitutions (banks, thrifts or credit unions) or

purchased by Fannie Mae and Freddie Mac, thefederally chartered mortgage institutions. Instead,a myriad of smaller and specialized non-depository lenders pioneered the subprime andAlt-A sectors, and regulatory agencies did notrequire these firms to collect and report data tothe same extent as their federally regulateddepository-institution counterparts.

Given these disclaimers about the limits ofour knowledge, we do know that the total amountof home mortgages outstanding at the end ofMarch 2007 was about $10.4 trillion. It appearsthat as much as $1.3 trillion of subprime mortgageswas outstanding at that time, along with aboutthe same amount of Alt-A mortgages (althoughdifferent data sources provide somewhat differ-ent estimates of this sector). Thus, the subprimeand Alt-A segments each represent 13 or 14 per-cent of the overall mortgage market. These sectorstogether accounted for only about 10 percent ofmortgage originations in 1995 (Chomsisengphetand Pennington-Cross, 2006).

The jumbo sector—comprising mortgageslarger than the maximum loan size eligible forpurchase by Fannie Mae and Freddie Mac—con-sisted of perhaps $2.5 trillion in March 2007,while prime, conventional, conforming mortgagescomprised the remaining $5 trillion.4 In terms of


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Table 1Incidence of Mortgage Debt on Primary Residence

Family income quintile

Percent of families that had some I V Allmortgage debt on a primary residence Lowest II III IV Highest families

1989 7.6 23.4 37.8 56.4 72.1 39.5

1995 10.4 25.9 38.2 59.1 71.4 41.0

2004 15.9 29.5 51.7 65.8 76.5 47.9

Change, 1989-1995 +2.8 +2.5 +0.4 +2.7 –0.8 +1.5

Change, 1995-2004 +5.5 +3.6 +13.5 +6.7 +5.1 +6.9

SOURCE: Survey of Consumer Finances, Board of Governors of the Federal Reserve System.

4 The market shares I cite were estimated by a prominent Wall Street investment firm, while other sources provide somewhat different marketshares. The precise numbers are not important for my purposes today.

the number of subprime borrowers, there areabout 7.5 million first-lien subprime mortgagesoutstanding (Bernanke, 2007c), out of a total ofmore than 50 million first mortgages.

Despite the heterogeneity in the non-primemarket, the bottom line is that more people haveaccess to mortgage credit now than ever before.The non-prime market has become very large; itis evolving constantly, and yet remains relativelyopaque. Despite its limitations and flaws, thenon-prime market has served a large number ofborrowers very well.

BROKERS AND REALTORS INTHE NON-PRIME MORTGAGEMARKET

One of the key features of the U.S. mortgagemarket is the large role played by independentmortgage brokers. Mortgage brokers are licensedand supervised by state, rather than federal,authorities and therefore the industry is not sub-ject to a single, consistent supervisory regimeacross the nation. The Bureau of Labor Statisticsreports that about 136,000 people were employedas “mortgage and non-mortgage loan brokers” inMay 2007, up from about 50,000 just ten yearsago. While the latest employment figure is downsomewhat from its recent peak in early 2006, thesector’s cumulative employment growth duringrecent years remains impressive (see Figure 1).

Mortgage brokers are especially important inthe non-prime sector. According to a privateresearch firm’s estimates, about 58 percent of allrecent residential mortgage loans involved a mort-gage broker, up from about 40 percent a decadeago.5 About 50 percent of prime mortgage trans-actions involve a broker, but brokers originatedaround 75 percent of subprime mortgages andabout 70 percent of Alt-A loans. Clearly, a non-prime borrower is especially likely to deal witha state-licensed and -supervised mortgage broker.

U.S. mortgage brokers are predominantlysmall, local firms—precisely the type of entre-

preneurial firm that contributes mightily to allsegments of the U.S. economy. It is quite plausiblethat these firms generally are more knowledge-able than larger lenders about local markets andborrowers and perhaps can be more responsiveand innovative. The employees of a local mort-gage broker are likely to be long-time residentswith a stake in the community.

It is clear that a firm operating with littlecapital investment enjoys some benefits. Onecould mention the ease of opening up a newbusiness, of increasing or decreasing the scale ofoperations, and of moving or closing down thebusiness. Operating under a regime of “light-touch” supervision also keeps costs low andenhances flexibility.

But the financial risk of operating with littlecapital is that shocks to the operating environ-ment—such as recent disruptions in secondarymarkets for non-prime mortgages—quickly candamage, if not destroy, the business. One of thebenefits of financial capital is that it can serve asa “buffer stock” of patient funding that will helpa firm survive adverse developments in its market.Clearly, many mortgage brokers are thinly capi-talized firms that are facing difficult times now insome markets and segments. Many have alreadyentered bankruptcy and others are likely to followgiven the scale of the current mortgage-marketdownturn. Significant exit from a market sectoris not a problem as long as subsequent entryremains relatively easy, as appears to be the casein mortgage broking.

There is reason for concern about this busi-ness model, however, when capital is so thin thatowners have little to lose if the business ceasesoperations. If the owners have a significant finan-cial investment in the business, and if this capitalcannot be withdrawn easily, then the key to prof-itability is long-term survival in order to earnreturns year after year on the invested capital.The owners always will keep one eye on theimmediate prospects for short-term profit andthe other eye on future profitability.

5 Simon and Hagerty (2007). The research firm whose estimates I cite is Wholesale Access, of Columbia, Maryland.

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In the mortgage-banking business, a durablestream of profits requires a continuing flow ofcustomers, both new and repeat business. Thebusiness also requires a continuing flow of capitalfrom investors willing to buy the mortgages amortgage originator wants to sell and securitize.Given the difficulty any mortgage broker likelyfaces in differentiating its own products, howcan a broker stand out from the crowd to becomea long-term survivor? One way is to give outstand-ing service to customers in the mortgage-shoppingprocess. Another way is to stand behind the workthe firm does and to be there when a previouscustomer (or investor) has a question or complaint.Turning these practices into future businessprospects, attracting both mortgage borrowersand investors, is precisely the role for reputation.

Advertising may help get out a firm’s name,but it is the firm’s good name and reputationspread through word of mouth that pays thehighest dividends.6 As former Federal ReserveChairman Greenspan aptly put it, reputation canbe thought of as a valuable asset in its own right:

Trust as the necessary condition for commercewas particularly evident in freewheelingnineteenth-century America, where reputationbecame a valued asset…In such an environ-ment, a reputation for honest dealing, whichmany feared was in short supply, was partic-ularly valued. Even those inclined to be lessthan scrupulous in their personal dealings hadto adhere to a more ethical standard in theirmarket transactions, or they risked being drivenout of business (Greenspan, 2005).


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25

50

75

100

125

150

05009590

150

125

100

75

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Figure 1

Employees of Mortgage and Nonmortgage Loan BrokersNot Seasonally Adjusted, Thousands of Employees

SOURCE: Bureau of Labor Statistics/Haver Analytics.

6 I do not mean to suggest that only mortgage brokers would benefit from greater investments in reputation and focus on the long term. Evensome large Wall Street firms active in underwriting, trading, and investing in non-prime mortgage-backed securities appear to have hesitatedin recent months when asked by some of their counterparties to prove that their reputations are of great value—to demonstrate the old adagein financial markets, “My word is my bond.” Given that these firms have large capital investments and that they deal repeatedly with eachother, one would have thought that reputation would be sacrosanct.

The non-prime mortgage business may notbe as freewheeling as nineteenth-century America,but it has come in for its fair share of criticismrecently, to be sure. A reputation for honest deal-ing surely would be an investment well worthmaking by many of today’s market participantsthat would pay dividends well into the future—not just for the firms building their reputations,but for all other market participants, as well.

Realtors also have an important responsibil-ity in the mortgage market. From happy experi-ence over the years, I myself know how valuablea realtor can be in providing advice and informa-tion on neighborhoods, their schools, quirks oflocal government and everything else a home-owner should discover before making a commit-ment to buy a particular house. Realtors can helppotential mortgage borrowers shop for mortgagesand select mortgage terms appropriate for theindividual circumstances of each borrower.

THE FEDERAL RESERVE ANDTHE NON-PRIME MORTGAGEMARKET

The Federal Reserve had followed develop-ments in housing and the non-prime mortgagemarkets very closely this year (Bernanke, 2007a,2007b, 2007c). A highly visible development isthe growing amount of financial stress amongsome of the millions of households with non-prime mortgages. We know that many non-primemortgage lenders and brokers have gone out ofbusiness or tightened their lending standards thisyear, reducing the flow of mortgage credit to bor-rowers unable to access the prime market. Finan-cial markets have dealt harshly, but on the wholeappropriately, with banks, hedge funds and cer-tain other investors who were heavily exposedto the riskiest segments of the non-prime securi-tized mortgage market.

While none of these developments is pleasantfor the lenders and financial firms most directlyaffected, one cannot help being impressed withthe even-handedness of it all. Until we receiveclear evidence that basically sound financialdecisions and arrangements were disrupted byerratic and irrational market forces, I believe weshould conclude that this year’s markets punishedmostly bad actors and/or poor lending practices.Lenders who made loans to borrowers withoutdocumentation, or who did not check borrowerdocuments that proved fraudulent, or who madeadjustable-rate loans to borrowers who could nothope to service the debt when rates adjusted up,deserved financial failure. As is often the case,the market’s punishment of unsound financialarrangements has been swift, harsh and withoutprejudice. While I cannot feel sorry for thelenders who have gone out of business, my atti-tude is entirely different toward the relativelyunsophisticated, but honest, borrowers whohave lost their homes through foreclosure. Manyare true victims.

Like other observers, we have noted withgreat concern the increasing delinquency andforeclosure rates on certain non-prime loan cate-gories during 2006 and 2007. Because Congresshas assigned to the Federal Reserve and to theFederal Trade Commission the primary respon-sibility of interpreting and implementing severalimportant consumer-protection statutes, wehave been undertaking a number of consumer-protection initiatives and actions.7 We have beenworking on revising required credit-card disclo-sures for several years and, beginning in 2006, wehave turned our attention increasingly to non-prime-mortgage issues. I will list briefly some ofthe more important recent Federal Reserve con-sumer-protection initiatives related to non-primemortgages:8

7 Most notably, the Federal Reserve is responsible for implementing the Truth in Lending Act (TILA, implemented as Regulation Z) and fordefining unfair and deceptive acts and practices under and the Home Mortgage Disclosure Act (HMDA, implemented as Regulation C) andits key amendments, the Home Ownership and Equity Protection Act (HOEPA), and under the Federal Trade Commission Act (FTC Act).The Fed’s enforcement authority, however, is limited to the financial institutions the Federal Reserve supervises directly.

8 For more details, see Chairman Bernanke’s Congressional testimony (Bernanke, 2007a).

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• In coordination with the other federalsupervisory agencies, we are encouragingthe financial industry to work with borrow-ers to arrange prudent loan modificationsto avoid unnecessary foreclosures.

• Federal Reserve banks around the countryare cooperating with community andindustry groups that work directly withborrowers having trouble meeting theirmortgage obligations.

• We are working with organizations thatprovide counseling about mortgage prod-ucts to current and potential homeowners.

• We are meeting with market participants—including lenders, investors, servicers andcommunity groups—to discuss their con-cerns and to gain information about marketdevelopments.

• We are conducting a top-to-bottom reviewof possible actions we might take to helpprevent recurrence of recent problems,including more-effective disclosures tohelp consumers defend against improperlending.

• We held five public hearings across thecountry during 2006 and 2007, duringwhich we gathered information on theadequacy of disclosures for mortgages, par-ticularly for nontraditional and adjustable-rate products (see Kroszner, 2007, for moreinformation).

• By the end of the year, we will proposechanges to TILA rules to address concernsabout mortgage loan advertisements andsolicitations that may be incomplete ormisleading and to require lenders to pro-vide mortgage disclosures more quickly sothat consumers can get the informationthey need when it is most useful to them.

• We have improved a disclosure that credi-tors must provide to every applicant for anadjustable-rate mortgage product to explainbetter the features and risks of these prod-ucts, such as “payment shock” and risingloan balances.

• We plan to exercise our authority under theHome Ownership and Equity ProtectionAct (HOEPA) to address specific practicesthat are unfair or deceptive, including butnot limited to pre-payment penalties, theuse of escrow accounts for taxes and insur-ance, stated-income and low-documentationlending, and the evaluation of a borrower’sability to repay.

• In coordination with the other federalsupervisory agencies, in 2006, the Fedissued principles-based guidance on non-traditional mortgages, and, in June of 2007,the Fed issued supervisory guidance onsubprime lending.

• We reviewed our policies related to theexamination of non-bank subsidiaries ofbank and financial holding companies forcompliance with consumer protection lawsand guidance.

• As a result of that review and followingdiscussions with the Office of ThriftSupervision, the Federal Trade Commissionand state regulators, as represented by theConference of State Bank Supervisors andthe American Association of ResidentialMortgage Regulators, we are launching acooperative pilot project aimed at expandingconsumer protection compliance reviewsat selected non-depository lenders withsignificant subprime mortgage operations.

Based on these activities, I think you willagree that the Federal Reserve takes its consumer-protection responsibilities in the area of non-prime mortgage lending very seriously.

CONCLUDING REMARKSEvery mortgage foreclosure is a tragedy for

the borrower, except perhaps those where theborrower participated in a fraud. Yet this obser-vation does not by itself suggest what can orshould be done to improve the functioning ofthe mortgage market. Based on my observationof financial markets, institutions and regulation


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over many years, I am convinced that we need tosearch for ways to strengthen borrower protectionswithout so increasing regulatory costs and risksto lenders that they withdraw from the non-primemarket. When we consider regulations designedto address abusive lending practices, we need tounderstand their possible impact on responsiblelenders. We will not be helping potential borrow-ers if we eliminate abuses by imposing regulationsthat have the unintended effect of eliminatingthe entire subprime market. My comment is nota counsel of despair, but a counsel of caution.Regulators need to be creative and not necessarilyinactive.

We need to emphasize individual responsi-bility and accountability in every corner of themarket. Lenders and brokers who put naive bor-rowers into unsuitable mortgages, which later gointo default, deserve the losses they suffer. Butthese lenders and brokers also lose a long-termbusiness opportunity. A successful borrower,who is able to stay current on a subprime mort-gage, can expect to become a prime borrower intime. Every mortgage lender or broker shouldwant that borrower to become a repeat customer.

Regulators should do what they can to helpeducate borrowers and encourage improvementsof incentives and business practices. If any ofyou believe there are ways the Federal Reservecan help in providing information, I hope youwill call on us so we can be partners in thisendeavor.

Thank you, and I’d be delighted to take yourquestions.

REFERENCESBernanke, Ben S. “Semiannual Monetary Policy

Report to Congress.” Presented to the Committee onFinancial Services, U.S. House of Representatives,July 18, 2007a, http://www.federalreserve.gov/boarddocs/hh/2007/july/testimony.htm.

Bernanke, Ben S. “The Housing Market and SubprimeLending.” Presented to the 2007 InternationalMonetary Conference, Cape Town, South Africa(via satellite), June 5, 2007b,

http://www.federalreserve.gov/boarddocs/speeches/2007/20070605/default.htm.

Bernanke, Ben S. “The Subprime Mortgage Market.”Presented at the Federal Reserve Bank of Chicago’s43rd Annual Conference on Bank Structure andCompetition, Chicago, Illinois, May 17, 2007c,http://www.federalreserve.gov/boarddocs/speeches/2007/20070517/default.htm.

Chomsisengphet, Souphala and Pennington-Cross,Anthony. “The Evolution of the Subprime MortgageMarket.” Federal Reserve Bank of St. Louis Review,January/February 2006, 88(1), pp. 31-56,http://research.stlouisfed.org/publications/review/06/01/ChomPennCross.pdf.

Greenspan, Alan. “Commencement Address.”Presented at the Wharton School, University ofPennsylvania, Philadelphia, Pennsylvania, May 15,2005, http://www.federalreserve.gov/boarddocs/speeches/2005/20050515/.

Kroszner, Randall S. “Encouraging ResponsibleMortgage Lending: Prospective RulemakingInitiatives.” Presented at the public hearing underthe Home Ownership and Equity Protection Act(HOEPA), Federal Reserve Board, Washington, DC,June 14, 2007.

Office of the Comptroller of the Currency, et al, JointPress Release, “Federal Financial RegulatoryAgencies Issue Final Guidance on NontraditionalMortgage Product Risks,” Sept. 29, 2006,http://www.federalreserve.gov/boarddocs/press/bcreg/2006/20060929/default.htm.

Office of the Comptroller of the Currency, et al, JointPress Release, “Federal Financial RegulatoryAgencies Issue Final Statement on SubprimeMortgage Lending,” June 29, 2007.

Quigley, John M. “Federal Credit and InsurancePrograms: Housing.” Federal Reserve Bank of St.Louis Review, July/August 2006, 88(4), pp. 281-309.

Simon, Ruth, and Hagerty, James R. “Mortgage MessShines Light on Brokers’ Role.” Wall StreetJournal, July 5, 2007, p. A1.

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APPENDIX

Classifying the Non-Prime Mortgage Market

There are several conceptually distinct approaches to classifying the various segments of the resi-dential mortgage market. The sector classifications sometimes overlap each other, and sometimes theycreate anomalies of various sorts. This appendix provides a brief introduction to some of the classifica-tion schemes used in the mortgage market.

Conventional vs. Non-Conventional. One way to split the market is to distinguish betweengovernment-insured or -guaranteed mortgages and the private, or “conventional” sector. The govern-ment (non-conventional) sector comprises mortgages made by private lenders but backed by the FederalHousing Administration (FHA) or the Veterans Administration (VA). Government-guaranteed mort-gages constitute only about 10 percent of the total market today.9

Conforming vs. Non-Conforming. Another way to split the mortgage market is to distinguishbetween mortgages eligible for purchase by Fannie Mae and Freddie Mac—so-called “conforming”mortgages—and all others (“non-conforming”). The conforming share of the market is perhaps 70percent in the sense that this fraction of borrowing households could qualify for a mortgage eligiblefor purchase by Fannie or Freddie if they chose to submit such an application. The actual purchasesmade by Fannie Mae and Freddie Mac were just over 50 percent of the total market earlier this decadeand now are below half. In addition, some conforming mortgages are held by the loan originators orsold to others without the intermediation of Fannie or Freddie.

The conforming market is entirely conventional and prime, but there are conventional and primemortgages that are not conforming. The non-conforming sector includes “jumbo” mortgages—thoselarger than the upper limit placed by law on Fannie and Freddie purchases—and others that fail to meetFannie and Freddie underwriting guidelines for one reason or another. The subprime, Alt-A and jumbosectors emerged from the conventional, non-conforming part of the mortgage market.

Subprime Mortgage Lenders vs. Prime Lenders. A third mortgage classification scheme is espe-cially important for understanding the subprime sector and federal consumer-protection efforts in thisarea. The U.S. Department of Housing and Urban Development (HUD) deems all mortgage loanssubprime that are made by a lending institution engaged primarily in that business line.10 While notideal from an analytical perspective because it lumps together some dissimilar mortgages and borrow-ers simply because they have a common originator, the HUD classification scheme is extremely impor-tant in practical terms.11 This classification convention is followed both for Home Mortgage DisclosureAct (HMDA) reporting purposes and by the Mortgage Bankers Association when compiling its widelyused mortgage-originations and -delinquency surveys.

Subprime Mortgage Products and Practices vs. Prime Products and Practices. A fourth approachto determining what the non-prime market is could be termed a product- and practices-based approach.Some consumer advocates have argued that certain mortgage features, product types or underwritingpractices are targeted to vulnerable populations, such as minorities, women, households with irregularincomes and others. These advocates argue that some features, products and practices—such as pre-


11

9 For more information on government mortgage programs, see Quigley (2006).

10 For details of HUD’s methodology and a list of subprime lenders, see the HUD website, http://www.huduser.org/datasets/manu.html.

11 For more information on HMDA and the Home Ownership and Equity Protection Act amendments to HMDA, seehttp://stlouisfed.org/hmdaregcamendments/default.html.

payment penalties, hybrid ARMs with introductory teaser rates, underwriting without regard to long-run mortgage affordability and yield-spread premiums paid to brokers by lenders—are deceptive andabusive in their own rights. In other words, the advocates argue that these features, products and prac-tices should be considered per se subprime—if not predatory—and deserving of greater oversight. Inthis view, some borrowers who could have qualified for a prime mortgage end up with more-expensivesubprime or Alt-A loans because they are part of a group that is targeted to receive a non-prime mortgage.

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