a household word. The subprime market in
the U.S. had grown remarkably over the past
decade, contributing to a rise in homeownership
rates. However, it took the sharp increase in delinquencies
and foreclosures in 2006 and 2007 for
the subprime market to capture the public spotlight.
Indeed, the sudden shift in fortunes in the subprime
market appeared to catch borrowers and lenders off
guard. In addition, the spillovers from the subprime
meltdown reached deep into financial markets, causing
substantial turmoil in the U.S. and abroad.
This report examines the developments in subprime
financing to help understand the factors
behind the sudden and substantial deterioration in
the subprime market, as well as the reasons for the
extensive impact on broader financial markets. The
report highlights the experience in the Twelfth District,
which has regions with some of the highest
concentrations of subprime lending.
This report argues that much of the growth and
success of the subprime market in the first part of the
decade was built on the rise in house prices and the
easing of underwriting standards, along with the use
of innovations in financing. The reversal in housing
market conditions quickly unmasked the vulnerability
of the subprime market, as softening house prices in
many markets greatly reduced the ability, as well as
the willingness, of some borrowers to keep mortgage
payments current. In addition, the turmoil that erupted
in financial markets was due to the widespread
distribution of exposure to subprime debt, as well as
more general doubts that arose concerning the value
of complex financial arrangements used to finance
subprime mortgages and other credit.
What is “subprime”?
There is no one definition of a subprime mortgage.
The classification “subprime” generally is a
lender-given designation for loans extended to borrowers
with some sort of credit impairment, say, due
to missing installment payments on debt or the lack
of a credit history.1 The industry sometimes lumps
subprime loans into the general class of nonprime
loans, which also includes the so-called alt-A loans.
Borrowers who receive alt-A loans generally have
higher credit ratings than subprime borrowers, but the
loans are viewed as nonprime because of some specific
feature of the loan arrangement, such as limited
or no documentation about income or assets, high
loan-to-value ratios, high payment-to-income ratios,
the purchase of a second home, or some combination
of these characteristics (see Box 1).2
There is no one definition of a subprime mortgage. The classification “subprime” generally is a lender-given designation for loans extended to borrowers with some sort of credit impairment, say, due to missing installment payments on debt or the lack of a credit history. Subprime mortgages can have fixed or adjustable
interest rates. Interest rates on adjustable rate mortgages
(ARMs) are pegged to a benchmark rate, such as the sixmonth
Libor rate3 or the one-year Treasury bill rate. As of
September 2007, for a sample of outstanding subprime
loans assembled by First American LoanPerformance
(FALP), the spread over various benchmark rates
averaged about 4 percentage points (see Box 2).
A feature of many subprime ARMs is a lower initial
rate that is fixed for a period of time before resetting
to the indexed rate. For example, the popular 2/28
ARMs reset to the fully indexed interest rate after the
first two years. While initial rates on many subprime
ARMs are lower than the reset rate, these initial rates
are notably higher than prime mortgage rates. The typical
subprime ARM in the FALP data set as of September
2007 had an initial rate of 8.0 percent, well above the
conventional 30-year fixed rate of about 6.2 percent
over the period in which the loans were originated.
Anecdotally, many subprime loans are not intended
as long-term financing for...