Risk and Price in the Texas and National Subprime Market. An Empirical Analysis. The Center for Statistical Research Alexandria, VA May, 2003

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1 Executive Summary Risk and Price in the Texas and National Subprime Market An Empirical Analysis The Center for Statistical Research Alexandria, VA May, 2003 Texas changed the legal regulation of mortgage lending in 1998 to allow "cash take out" refinances of existing mortgages and stand alone first and second mortgage lending for home equity purposes. Following that development, a market opened in Texas for home equity lending for the first time, and as part of that market a small subprime mortgage market began to develop. This study examines the subprime mortgage market that is growing in Texas, and specifically whether risk and price are closely correlated in that market. Some critics of subprime lending have claimed, without a substantial empirical basis, that there is "overpricing" in the subprime market. Overpricing is a particular concern with subprime mortgage lending, because most of those who use subprime first mortgages are middle to lower middle class. The idea of "overpricing" also appeals to social activists, because they see subprime loans as predominantly used by low income borrowers (although that does not appear to be the case). The claim confirms their belief that disadvantaged members of the society could obtain credit if only credit prices were lower. Using data from several empirical databases, this study examines subprime lending in Texas, and particularly the relation of price to risk. To place the emerging Texas market in context, it compares Texas subprime lending to the national subprime market. The study finds that price and risk are closely correlated in both the national and Texas markets for subprime lending. Specifically, the study looks at the delinquency and default experience associated with different price categories of subprime loans. It finds that default and delinquency experience significantly increases as the price (interest rate, points, fees) charged for the loan increase. It has long been hypothesized that subprime lenders charge higher prices for subprime loans to cover higher delinquency and default expenses and losses with these loans. This study finds that is the case. Specifically, as the price of a loan increases, so does the default and delinquency experience. As expected, subprime lenders are apparently charging more to borrowers because they are more expensive to lend to. This relationship between price and risk is what an efficient competitive market for subprime mortgage loans would produce, and is consistent with, and supports the conclusion that, the subprime mortgage market is an efficient, competitive market. Overall, the study concludes that the available empirical evidence does not suggest in any way that market dysfunction exists in the subprime market. 1

2 Risk and Price in the Texas and National Subprime Market Background: The Underwriting Decision in an Efficient Market. In an efficient market, mortgage loans are provided to borrowers based on the lender's assessment of the risk of making the loan. Once that risk is assessed, the lender prices the loan at a level that the lender predicts will allow it to cover its costs and make a profit. The higher the risk, the higher the price. The lender's prediction of how likely it is the borrower will repay is the critical part of this process and is unique to lending. 1 No lender makes a loan that is expected to default since such loans result in costs and losses that soon overwhelm revenues earned from interest and fees. 2 Moreover, no lender can know at the time a loan is made whether the borrower will repay on time, or have difficulty repaying, or default. Instead, the lender can only make a prediction for each borrower how likely, up and down a continuum, the borrower is to have difficulty repaying on time, or default. Borrowers are classified into groups based on these predictions, and their loans are priced accordingly. Most borrowers with the highest risk of default who pay the highest prices for credit will successfully repay the loan without interruption. A few will have significant difficulty, and an even smaller group will fail to repay. How well a lender classifies borrowers into risk classes and prices accordingly determines if the lender is profitable. Over time, competition among lenders prevents any one lender from overcharging. A lender whose prices are regularly too high or too low relative to risk quickly loses market share, and profitability evaporates as the fixed costs of running a large lending operation overwhelm revenues. In a market that is not efficient, a different scenario unfolds. Borrowers with low levels of risk but lacking sophistication in protecting themselves wind up being charged more for their loans than their underlying risk justifies. Risk is not correlated with price. In popular terms, some borrowers "pay too much" or, more colorfully, are "gouged", for the credit they receive. Given how widespread mortgage lending is, and given how important fair pricing of mortgage loans is considered to be, it is not surprising that there is concern whether subprime mortgages are priced as they should be in an efficient market. This concern leads to focus on the lender's decision to make a loan at a particular price. Is that price one a particular borrower would pay in an efficient market, or is it excessive given that borrower's risk? As a matter of social policy, there is widespread agreement that borrowers should pay for credit based on their actual level of risk. Otherwise, one class of borrower is 1 There are significant similarities between the predictions involved in lending and in underwriting life and health insurance. In both, the success of the company is dependent on accurately predicting an event that it is impossible to know in advance. In lending, it is whether the borrower will miss payments or default. In insurance, it is whether the borrower will get sick, or when he or she will die. 2 Critics of subprime lending have claimed that subprime lenders make loans they know will default just to foreclose on borrowers' properties. Despite the frequency with which this claim is made, we have been unable to find any empirical evidence or formal study that provides credible evidence that this has been the case. We are therefore unable to evaluate these claims. 2

3 likely to end up paying for the costs of serving borrowers with a higher risk level. For example, if relatively low risk borrowers are charged too high prices relative to risk, and higher risk borrowers are charged prices that are low relative to the risk they present, one class of borrower "subsidzes" the other unfairly. In an efficient market, the lender's decision about whether to make a loan and, if so, at what price, results in borrowers paying according to their level of risk because the lender will set the price for the loan based on the borrower's risk of slow- or nonpayment; i.e., on the predicted cost of serving a particular class of borrowers like the actual borrower. The lender's decision whether to make a particularly loan -- whether prime or subprime -- is commonly called "underwriting" in the mortgage industry. Underwriting is a fairly complex process, involving assessing how likely a particular borrower is to be able to repay a particular loan, and how expensive it will be to manage the loan during the repayment process. Ultimately, the quality of a lender's underwriting determines whether the lender survives. The risk entailed in a loan reflects the difficulty the lender can expect in getting paid back. Borrowers who are chronically late cost a lender money even if they eventually pay, since reminders must be sent out, and followed up with collection activity if the payment does not come in following the reminder. Borrowers who ultimately fail to pay are even more costly, since the lender then incurs the out of pocket costs of a collection agency or equivalent and, if all else fails, the foreclosure process, as well as suffering loss from whatever ultimately remains uncollected. Underwriting subprime loans includes in part the same sort of analysis as for prime loans. However, subprime loans are not just prime loans with a higher price and somewhat more risk. They have a different cost structure from prime loans. At the start, subprime loans have higher delinquency and default experience than prime loans. Delinquency increases servicing costs; default losses obviously also raise the cost of providing the loan. But subprime loans also prepay differently. They prepay both when mortgage rates fall and when a borrower's credit risk profile improves. Prepayment risk, an important factor in the cost of funds, is therefore higher with subprime loans. Moreover, as a group of subprime mortgages ages, the loans that remain in the portfolio get more risky because borrowers with good credit prepay in order to refinance with a better rate, leaving behind the riskier mortgages owed by borrowers whose credit has not improved. 3 The critics' claims. Some critics of the subprime mortgage market have claimed that price and risk are not correlated. One analysis conducted by research staff at Freddie Mac claims that many prime borrowers are served by subprime lenders, and so pay higher costs for mortgages. 4 Since in an efficiently operating marketplace prices would 3 Fred Phillips-Patrick, Eric Hirschhorn, Jonathan Jones, and John LaRocca, What About Subprime Mortgages? 12 (Research and Analysis, Office of Thrift Supervision June, 2000). 4 Howard Lax, Michael Manti, Paul Raca and Peter Zorn, Subprime Lending: An Investigation of Economic Efficiency (unpublished paper, February 25, 2000). Both Freddie Mac and Fannie Mae have for 3

4 directly reflect the risks of providing credit, this claim suggests that the subprime mortgage market suffers from inefficiency, with the possible result that a significant group of borrowers pay too much for the credit they receive. This is a politically potent claim, since historically politicians have been easily persuaded that credit is overpriced and credit markets inefficient. No one likes a creditor which overcharges. The Evidence. However, although the Freddie Mac analysis has been widely cited by critics of subprime lending, that effort appears to be the only one which has reached a similar conclusion, 5 and it is unclear on what empirical evidence the results were grounded. The staff apparently looked at the files of a group of loans that Freddie Mac had purchased as subprime loans during the relatively short period that Freddie Mac was buying subprime loans. The limited sample may have reflected Freddie Mac's admittedly tight purchasing requirements. On the other hand, a study by the Office of Thrift Supervision research staff reached quite different conclusions. The study, by the Research and Analysis division at the Office of Thrift Supervision, used a proprietary database collected by Loan Performance Systems (formerly Mortgage Information Corporation) which provided information about approximately 1.8 million subprime loans up to the end of Using the information available in that database, the price of subprime loans was correlated with the delinquency and default experience. Looking at pricing, delinquency rates and at what risk level the lender classified the loan using an A-, B, C and D scoring system, the study concluded that "most of the evidence from the [Loan Performance System] subprime database is broadly consistent with a well-functioning market. Coupon rates, for example, increase steadily as grade and credit scores decline." 6 The Freddie Mac analysis and the Office of Thrift Supervision study appear to be the only formal studies that use empirical evidence to address whether risk and price in subprime lending are appropriately correlated. This is not because of lack of interest, or lack of widespread claims by critics of subprime lending that risk and price are not correlated. The problem is obtaining data that permit the question to be addressed. Until recently, there has not been any widely available database on subprime mortgage lending some time considered entering the subprime market, and have done so at various points in time. Eventually, however, they have withdrawn as the risks -- political and economic -- become apparent. Since both agencies enjoy what amounts to a federal guarantee of their investment securities, they benefit from lower costs of funds than private lenders. However, their high political visibility makes it difficult for them to manage the high risk lending in the subprime market. Because they are potential competitors of current subprime lenders, their claims that they could do better may be influenced by a desire to obtain political approval to become significant factors in the subprime market. 5 Kenneth Temkin, Jennifer E. H. Johnson & Diane Levy, Subprime Markets, The Role of GSEs, and Risk- Based Pricing, 20 (U.S. Department of Housing and Urban Development Office of Policy Development and Research, March, 2002). 6 Fred Phillips-Patrick, Eric Hirschhorn, Joanthan Jones, and John LaRocca, What About Subprime Mortgages?, 12 (Research and Analysis, Office of Thrift Supervision June, 2000). The study did find that 16% of A- rated mortgages had FICO scores over 680, leading the study to observe that "we cannot determine whether overpricing exists [in the loans with 680 score or higher], but the data certainly raise the issue". Id. at 10. 4

5 which provides pricing, risk and performance information which would enable an examination of whether and how well subprime loans repay in relation to the prices charged. As a result, there has been very little empirically based information on how well the subprime market functions. This Study. Using a different database covering considerably more subprime loans than the Loan Performance System database, and supplementing information from that database with data from the U.S. Bureau of the Census, data collected under the Home Mortgage Disclosure Act ("HMDA") and data on delinquency and foreclosure starts compiled by the Mortgage Bankers Association, this study examines the relationship of risk and price in the subprime market in Texas and nationally. It finds that price and risk are closely correlated in subprime mortgage lending, strongly suggesting that subprime lending prices are closely influenced by the risks of collection expense and losses in foreclosure. In other words, nationally and in Texas, risk and price appear to be closely related, as we would expect in an efficient market for subprime loans. Borrowers as a class who pay higher prices appear to do so because it costs more to provide credit to them. After extensive examination, there is no evidence of significant market malfunction in the pricing of subprime loans. The Database. The database used for much of the evidence presented in this study is the AFSA database of subprime loans. In the summer of 2000, the American Financial Services Association (AFSA) commissioned PriceWaterhouseCoopers (PWC) to collect loan-level data on subprime mortgages from nine AFSA member companies. Originally, the dataset began with loans originated from July 1, 1995 to June 30, However, recently the data was updated to March 31, All of the loans in the resulting data set are loans secured by residential real estate (either first or second lien). Thus, the data set includes all such loans originated by the subprime divisions of the participating companies between July 1, 1995 and March 31, The AFSA subprime database ending with the first quarter of 2002 included data on over 3.4 million loans. It contains information on both closed end and open end loans, retail originations (60%) and wholesale (40%) purchases. Loan records provide interest rate and APR, an index of creditworthiness, loan amount, property zip code, whether the loan is a first or subordinate lien, information on delinquency, foreclosure and write off, prepayment and other information. Average loan amount is $52,600, somewhat lower than the average loan amount in the Loan Performance System database. Loans originated by reporting companies average $44,500, while purchased loans average $64,000. The AFSA database is large, and it also appears to give an extremely broad picture of subprime mortgage lending, particularly in comparison to the other databases researchers sometimes use. Slightly more than half of the loans are first liens, and slightly less than half are subordinate, compared to the 90% first, 10% second distribution reported in 2000 to be in the Loan Performance Systems database by the Office of Thrift Supervision research staff when they examined that database. 7 We estimate that more than 60% of the loans in the AFSA database are not included in the 7 Fred Phillips-Patrick, Eric Hirschhorn, Jonathan Jones, and John LaRocca, What About Subprime Mortgages? (Research and Analysis, Office of Thrift Supervision June, 2000). 5

6 HMDA subprime database. 8 Five of the lenders that report to the AFSA database also report to Loan Performance System. A Profile of Subprime Mortgages and Borrowers, National and Texas Markets At the outset, it is important to note that the Texas market for subprime mortgages has only recently developed. Starting in 1998, Texas first authorized home equity lending. Until that date, lending secured by a Texas homestead was illegal unless the loan proceeds were used to purchase a home or to refinance only the unpaid balance of a purchase money mortgage loan. In 1998 and the four years since, a market for home equity loans developed in Texas, including a subprime home equity market. Chart 1 below shows the distribution of subprime loans, both purchase money and home equity, by origination year in the AFSA database. As the chart shows, the Texas subprime market is a relatively recent one for the companies providing data to the AFSA database, as we would expect given that Texas only recently authorized home equity lending. As a young market, it is possible that the Texas market may have some characteristics that reflect a "sorting out" that sometimes occurs in a recently opened marketplace. 9 To control for that possibility, this study compares Texas with national data at many points. Chart 1: Percent Distribution of Texas Subprime Mortgages in AFSA Database, by Year % % % Only approximately 20% of the loans included in the AFSA Q database would be captured in the HMDA subprime database based on the HUD 2000 subprime list and previous HUD subprime lender lists. Because of changes in the list affecting the 2001 data, we estimate that about 30% more of the loans in the AFSA database that were originated in 2001 would also be in the HMDA 2001 subprime database. HUD revises its list of "subprime lenders" each year, and in 2001 added Household and Chase/Advanta. 9 Information collected by the Texas Office of Consumer Credit Commissioner from all home equity lenders in Texas indicates that home equity loan volume jumped to 114,823 first lien loans and 28,500 second lien loans in 1998 and then has slowly tapered off to 39,252 first lien loans and 5,865 second lien loans originated in Prime and subprime loans are included in these statistics. Only a relatively small proportion of these loans would be subprime. For example, loans in the AFSA database originated in 2001 that were presumably included in the loans the OCCC reported as originated that year amount to only 12% of the OCCC total. 6

7 In the past, very little loan level information has been known about subprime mortgages. For example, it is recognized that first and second mortgages have significantly different risk characteristics for lenders, but it is not known if significant differences exist between first and second mortgage borrowers and the loans they obtain, or between lending and borrowing in different states. Chart 2 shows the relative frequency of first and second mortgages, both in Texas 10 and nationally. Chart 2: Comparison of Relative Distribution of Firsts and Seconds for National and Texas Subprime Mortgages, Q to Q firsts seconds National Texas Interestingly, Texas has a much smaller market for second mortgages than nationally, where slighly less than half of subprime loans are second mortgages. There may be regulatory reasons for this 11, or market differences between Texas and nationally. But it points out that certain state markets may have somewhat different conditions than the national market overall. Other available statistics permit a more extensive comparison of Texas with the rest of the United States. The United States Bureau of the Census compiles information on mortgage borrowing in the Unites States as part of the decennial collection of census information. Using 2000 census information, we can establish the populations of Texas and the United States in 2000 as well as the extent of occupancy of homes by homeowners (as opposed to tenants) nationally and in Texas for the same year. Combining that information with HMDA data, we can then compute levels of subprime lending relative to total population and homeownership both nationally and in Texas. HMDA data provides information on the number of mortgages that were originated in 2000, and the Department of Housing and Urban Development has developed a list of 10 The relatively low level of Texas second mortgage loans compared to first mortgage loans is confirmed by the statistics compiled by the Texas Office of the Consumer Credit Commissioner, which showed that in 2001, there were 39,252 prime and subprime home equity first mortgage loans made and only 5,865 prime and subprime home equity second mortgage loans made by home equity lenders in Texas Texas requires licensing for second lien home equity lenders, while it does not for first lien lenders. By reputation, the regulation of second lien lending in Texas is very stringent. 7

8 purporting to identify which HMDA reporting lenders are subprime lenders, a list commonly known as the HUD Subprime Lender List. Using that list, the Center for Community Change of Washington D.C. has compiled for the year 2000 the number of subprime loans originated in each metropolitan statistical area ("MSA") in the country. We compiled all of the subprime loans originated in 2000 in Texas from that list to provide a count of the number of subprime mortgages originated in a Texas MSAs by lenders on the HUD Subprime Lender List during Although there are problems of over and underinclusion of subprime loans inherent in the HMDA subprime lender list methodology, the results shown in Chart 3 below provide some information about Texas subprime lending in relation to the number of available homeowners in comparison to national levels of borrowing. Chart 3: Extent Borrowers Obtain Subprime Loans: United States as a Whole and Texas 0.70% 0.60% 0.50% 0.40% 0.30% 0.20% 0.10% Subprime loans originated in 2000 as a percent of total population Owner-occupied units obtaining a subprime mortgage in 2000 U.S. Texas Clearly, subprime lending is significantly more frequent per capita and per homeowner in the United States as a whole than in Texas. Once again, this may because of regulatory restrictions already in place in Texas, the relative newness of the subprime market there, or economic, cultural or other factors. Whatever differences there may be between Texas and the nation as a whole with regard to subprime lending, it does not appear to be because of the incomes Texans enjoy. Texas median household income as reported by the U.S. Census Bureau for the 2000 census, at $39,927, is only slightly below the national median household income of $41,994. However, looking at the Texas and national housing markets, there are some important differences. Texas housing, on average, is cheaper than nationally based on United States Bureau of the Census information for the year Approximately 60% of Texas housing is valued at $100,000 or less compared to 40% nationally; Texas has more than twice as much housing valued at under $50,000 than nationally. Lower housing values may make it harder for Texans to obtain lower cost subprime loans, since there is less home equity available to support borrowing. Chart 4 presents the differences between housing values in Texas and the United States for homes up to $150,000. 8

9 Chart 4 : Value of Housing, United States as a Whole and Texas U.S. Texas 1 < $50k $50k-$99.9k $100k-$149.9k Texans tend to be somewhat less heavily mortgaged than nationally, consistent with the lower levels of subprime mortgage lending indicated above. Table 1 presents U.S. Census Bureau data on the percent of household income spent on selected housing costs, including mortgage payments. Table 1: Selected monthly owner costs as a percentage of household income in 1999, U.S. and Texas Source: United States Bureau of the Census, Year 2000 U.S. Texas >15% 36.50% 40.70% 15 to 19.9% 17.50% 18.20% 20 to % 13.20% 25 to % 8.20% 30 to % 5.00% >35% 15.80% 13.60% As Table 1 shows, Texans spend less of their household income on housing related costs, including mortgage payments, than on average do borrowers in the rest of the United States. The general picture which emerges is that the Texas mortgage market tends to provide less mortgage credit per capita to Texans than occurs in the rest of the United States, and this is true of mortgage borrowing across the board, whether prime, subprime or FHA/VA. To look more closely at subprime borrowing in Texas and nationally, we have to look at the profile of subprime borrowers. Who Are Subprime Borrowers? The AFSA database allows us to look at the age, income, race (to some extent) and credit profile of borrowers. Chart 5 shows the age distribution of Texas and national subprime borrowers. 9

10 Chart 5: Texas and National Subprime Mortgages: Age Distribution of Borrowers Texas National < As you can see, more than two thirds of both first and second mortgage borrowers are below age 55, with about 65% in Texas and 70% nationally of borrowers younger than that age. In Texas 87% and nationally 89% of borrowers are younger than 65. Only 11% - 13% are over 65. Chart 6 gives a picture of the relative income of subprime borrowers both nationally and in Texas. Interestingly, what emerges is that first mortgages tend to be more available to borrowers with lower incomes than second mortgages, while second mortgages tend to be predominantly concentrated in higher income borrowers. Over 60% of both Texas and national subprime borrowers obtaining first mortgages have incomes of $50,000 or less, while 83% of them have incomes of $75,000 or less. This is not to say that subprime first mortgage lending is a low income product. More than 80% of subprime first loans are made to borrowers with incomes over $35,000. Given Texas' U.S. Bureau of the Census median household income of about $39,600 in 2000 and the national median household income of about $41,900 for the same year, clearly the subprime product is one which is predominantly used by borrowers with average to above average incomes. However, the first mortgage is not predominantly a product for borrowers with incomes of $75,000 or more. On the other hand, the second mortgage is much more a higher income product. More than 85% of both Texas and national borrowers have incomes over $35,000, and more than 65% have incomes over $50,000, while 35% or more have incomes over $75,000. The second mortgage appears to require a relatively high income, perhaps because it is viewed by lenders as considerably more difficult to collect by foreclosure than a first mortgage. 10

11 Chart 6: National and Texas Subprime Mortgages: Percent Distribution of Borrower Income for First and Subordinate Mortgages % % Texas firsts National firsts Texas seconds National seconds % % < $15000 $15K- $24.9K $25K- $34.9K $35K- $49.9K $50K- $74.9K $75K- $99.9K >$100K What about the race of borrowers? Although the AFSA database does not collect information about the race of borrowers, it does obtain the zipcode of the mortgaged property, which enables us, using U.S. Census Bureau data, to identify mortgages on properties in neighborhoods that have heavily concentrated minority populations. Chart 6 shows the extent to which Texas subprime mortgages are being made in black and hispanic concentrated zipcodes. Chart : Percent of Subprime Texas Mortgages Made in Neighborhoods That Are More Than 75% Black or Hispanic % % firsts seconds >75% black >75% hispanic What is apparent is that zipcodes in which African-Americans are heavily concentrated are not large consumers of subprime loans. Hispanic concentrated neighborhoods are somewhat more likely locations of subprime lending. Still, this information casts 11

12 substantial doubt on the frequent charges by critics of subprime lending that subprime mortgages are "targeted" on poor, minority concentrated neighborhoods. Other studies using HMDA data have suggested that race is a factor in subprime lending, both nationally and in Texas. 12 These studies have found that HMDA data on mortgage lending, when separated into subprime loans and prime loans using the HUD Subprime Lender List, indicate that by a small but significant percentage minority borrowers obtain subprime loans more frequently than non-minority borrowers. There are significant questions, which need not be explored here, whether this method results in accurate identification of which loans are subprime. As HUD itself recognizes, the HUD Subprime Lender List may well not identify subprime loans particularly well. 13 However, assuming that these studies' results are based on an 12 Randall M. Scheessele, Black and White Disparities in Subprime Mortgage Refinance Lending (Office of Policy Development and Research, Department of Housing and Urban Development 2002); U.S. Department of Housing and Urban Development, Unequal Burden: Income and Racial Disparities in Subprime Lending in America (April, 2000). U.S. Department of Housing and Urban Development, Unequal Burden in Atlanta: Income and Racial Disparities in Subprime Lending (April, 2000); U.S. Department of Housing and Urban Development, Unequal Burden in Los Angeles: Income and Racial Disparities in Subprime Lending (April, 2000); U.S. Department of Housing and Urban Development, Unequal Burden in New York: Income and Racial Disparities in Subprime Lending (April, 2000); U.S. Department of Housing and Urban Development, Unequal Burden in Baltimore: Income and Racial Disparities in Subprime Lending (April, 2000); U.S. Department of Housing and Urban Development, Unequal Burden in Chicago: Income and Racial Disparities in Subprime Lending (April, 2000). More academic studies have likewise used this methodology. Abt Associates Inc., Analyzing Trends in Subprime Originations and Foreclosures: A Case Study of the Atlanta Metro Area (February, 2000); Abt Associates Inc., Analyzing Trends in Subprime Originations and Foreclosures: A Case Study of the Boston Metro Area (February, 2000); ACORN, The Great Divide 2002: An Analysis of Racial and Economic Disparities in Home Purchase Mortgage Lending Nationally and in Sixty-Eight Metropolitan Areas (Oct. 1, 2002)(available on November 12, 2002 at Calvin Bradford, Risk or Race? Racial Disparities and the Subprime Refinance Market (May, 2002)(prepared for and published by the Center for Community Change)(found on September 9, 2002 at Harold Bunce, Debbie Gruenstein, Christopher Herbert & Randall Scheessele, Subprime Foreclosures: The Smoking Gun of Predatory Lending? (undated)(available at (HUD User website))(uses HUD subprime list of lenders to determine which loans in a database of foreclosed loans derive from subprime loans); California Reinvestment Committee, Predatory Lenders Feed on the Poor, Seniors and People of Color (November 29, 2001)(press release); Consumers Union, Minority Subprime Borrowers (October 2002)(Texas)(found November 12, 2002 at Keith Ernst, John Farris & Eric Stein, North Carolina's Subprime Home Loan Market After Predatory Lending Reform, 4, 11 (obtained on August 15, 2002 from ww.responsiblelending.org.); Keith D. Harvey & Peter J. Nigro, Do Predatory Lending Laws Influence Mortgage Lending? An Analysis of the North Carolina Predatory Lending Law (September 2002)(paper presented at the Subprime Lending Symposium on September 17, 2002 at Georgetown University)(in author's files); Daniel Immergluck, Stark Differences: The Explosion of the Subprime Industry and Racial Hypersegmentation in Home Equity Lending (2000)(Woodstock Institute Paper); Daniel Immergluck and Marti Wiles, Two Steps Back: The Dual Mortgage Market, Predatory Lending, and the Undoing of Community Development (1999)(The Woodstock Institute); NTIC, Preying on Neighborhoods: Subprime Mortgage Lenders and Chicagoland Foreclosures (May, 2000). 13 See, e.g., cautionary statement accompanying 2001 HUD subprime lender list in from Randall M. Scheessele November 25, 2002 (attached document entitled "sub_2002_distributed.doc"). 12

13 accurate division between prime and subprime loans, their findings are not very useful because their results do not demonstrate that minority borrowers inappropriately receive subprime loans rather than prime loans. They only point out that minority borrowers proportionately obtain more subprime loans than do non-minority borrowers. HMDA data does not provide either the prices borrowers pay for the mortgages the HUD Subprime List categorizes as "subprime", the borrowers' credit scores, the value of the property they have to offer as collateral, or any means to track the actual delinquency and foreclosure experience of borrowers who obtain subprime loans as opposed to borrowers who obtain prime loans. As a result, it is not possible to determine from HMDA data if borrowers who obtain subprime loans appropriately did so. 14 It may be that the market is appropriately providing subprime credit to borrowers based on their actual risk of nonpayment. What about the FICO scores of subprime borrowers? The FICO score of borrowers is widely used in the lending industry as one of the factors considered in determining the risk a particular loan entails. This composite score, developed using a methodology designed by Fair, Issacs and Company (hence, "FICO"), combines in a particular way information in the borrower's credit history, and is recognized in the industry as often a good, although not the only, indication of the risk loaning to a particular borrower will entail. 15 It is important to recognize that the FICO score only captures the borrower's repayment history. Repayment history only includes whether the borrower paid on time in the past and such factors as the historic amount the individual has borrowed, the size of credit lines the individual has maintained, the number of inquiries from potential lenders, and the duration of accounts -- how long the individual has maintained customer relationships with lenders. It does not reflect anything about the value of the borrower's property, his or her equity in the home, or his or her income, employment history or job stability. Moreover, the FICO score is only intended to predict the probability that the borrower will have a major default. 16 It does not predict frequency of minor delinquencies (which can significantly raise lender's costs). As a result, the FICO score's usefulness for subprime lending underwriting may be less than for prime lending. In fact, we have been told that in subprime lending, FICO 14 Starting with HMDA reporting due in 2004 (covering year 2003 originations) some of these deficiencies will be addressed. However, even with the additional information that HMDA reporters will then be required to provide, and the expanded reporting for a broader range of lenders, data from this source still will not provide actual data on how well loans performed. Therefore, it will not permit relating interest rates charged to delinquency and default. As we point out below, this appears to be the best way to understand how well price and risk are related. 15 The FICO score does not cover everything there is to say about credit risk. For some types of borrowers, lenders may find that the FICO score is not as accurate a predictor as other factors. They may substitute in whole or in part for the FICO score independent consideration of such factors as the borrower's income and job stability, the size of the loan in relation to the borrower's income and existing obligations, and the value of the security property and its likelihood of realization upon resale, as well as other specialized considerations having to do with what can interfere with repayment. 16 Technically, the FICO score predicts the probability that the borrower will experience over the next 2 years a serious delinquency (60+days), chargeoff, bankruptcy, tax lien or judgment lien. 13

14 score is less accurate in predicting the risk a particular loan presents than in prime lending. Nonetheless, it remains one indication of the relative ease with which the borrower can qualify for credit. For the purposes of the following discussion, we have more or less assumed the rule of thumb that a borrower with a FICO score of 680+ minimally qualifies, all other things being equal, for prime credit. Of course, if the borrower has uncertain employment, weak collateral, a very tight budget, or other negative factors, a credit score of 680 or higher may not be enough to qualify for prime credit. Chart 8 shows the relative percent distribution of FICO scores of Texas and national borrowers. Chart 8: Percent Distribution of FICO Scores of Subprime First and Second Mortgages, in Texas and Nationally Texas Firsts National Firsts Texas Seconds National Seconds > Earlier when we reviewed the distribution of borrower income relative to subprime lending, it was apparent that the subprime first mortgage was primarily a product for borrowers with incomes below $75,000, with 60% of subprime loans, both nationally and in Texas, made to borrowers with incomes under $50,000. Similarly, subprime first mortgages both in Texas and nationally tend to be for borrowers with low FICO scores, although not invariably. Over 75% of subprime first mortgages are made to borrowers with FICO scores under 640. Another 15% or so have FICO scores in the 640 to 679 range. Using 680 as a preliminary dividing line between borrowers with obviously impaired credit and those without serious impairment, over 90% of subprime borrowers fall in the seriously impaired category. We saw earlier that subprime second mortgages both in Texas and nationally are very much a product for the higher income borrower, and it turns out that nationally that is correlated with borrowers with relatively favorable FICO scores -- borrowers with a fairly good record of repayment, although not necessarily good job stability, home value, home equity or other factors considered important in determining risk. In Texas this latter point is less true. In Texas, second mortgages are considerably less likely to be given to higher FICO score borrowers than nationally. Of course, second mortgages are also a very small part of the Texas subprime market relative to national markets. 14

15 Pricing of Loans. Much of the hostility that critics of subprime lending express probably arises from the fact that subprime loan interest rates, points and fees are set over comparable interest rates, points and fees for prime mortgages. The United States has a long history of suspicion of lenders in general, and particularly lenders which charge more than middle class borrowers are accustomed to pay. For these and other reasons previously discussed, the pricing of subprime loans becomes an important point for examination. Chart 9 presents information on the percent distribution of prices of Texas and national subprime mortgages. Because mortgage rates vary over time with the overall cost of funds, absolute interest rates or annual percentage rates calculated under federal Truth in Lending ("APR") cannot be used to compare price and risk from one period to the next. We therefore used the difference between the APR reported for the loan and Treasuries of comparable maturity as of date of origination for every loan in the database (referred to as the "spread" or "premium") as the indicator of loan pricing. The APR, of course, reflects both the interest rate, points and some fees paid on the loan, and therefore gives an accurate overall picture of the price charged for the loan. Chart 9: Texas and National Subprime Mortgages: Price Distribution of Firsts and Seconds Texas Firsts National Firsts Texas Seconds National Seconds < >7 It is clear that in Texas there are more loans than nationally priced over 7 percentage points over Treasuries, both with regard to first and second mortgages. Conversely, there are fewer loans priced below 4 percentage points over Treasuries in Texas than nationally. Although this difference between Texas and national pricing at first appears surprising, as we will see below, Texas pricing correlates closely with the actual delinquency and foreclosure experience which subprime lenders are experiencing in Texas. The relatively lower home values in Texas than nationally may have an impact here, as may other factors unique to the Texas market such as job and income stability for borrowers who obtain subprime loans. 15

16 How Well Are Risk and Price of Subprime Mortgages Correlated in Texas and Nationally? We have already discussed that in an efficient market, the price for a loan should reflect its risk of slow or non-payment. Since we know that in an efficient market price and risk are correlated, we can inquire whether a loan market is operating efficiently by examining whether as loan prices increase, lenders experience increased occurrence of events that are known to cause higher lender costs -- like delinquency and default. If they do, there is a strong indication that the market is operating efficiently and that borrowers are appropriately being charged more for the loans that are made to them. The reverse is also true. If borrowers who are being charged higher prices do not have higher delinquency or default experience, it would be suggestive, absent some adequate explanation, that the market was not appropriately charging borrowers as it should in an efficient market. Study Design. This study correlates the prices charged for subprime loans in Texas and nationally with the delinquency and default experience on those loans. Specifically, we tabulated how many loans were 60 days or more past due as of the time the database was reported, or were in the foreclosure process, or on which foreclosure had been completed as of that time. The database was reported as of the end of the first quarter of 2002, or March 31, These results were then correlated with the range of prices charged for the loans to see how closely the pricing tracked the risks that actually existed in the portfolio. Using a methodology explained above, we determined the difference or "spread" between the APR for each loan and Treasuries of comparable maturity as of the date the loan closed, and grouped loans into pricing categories based on that difference. Of course, this approach second guesses the underwriting of the industry, perhaps with some degree of unfairness. Underwriting is inherently a prediction of the future, and the future does not always turn out as expected. However, this approach does give significant insight into whether over a period of years the subprime mortgage lenders in this study were accurately pricing the loans they made, as should occur over time in an efficient marketplace. There is perhaps a need for an additional word of caution. People unfamiliar with lending often find the function of underwriting confusing. An underwriting decision places a particular loan applicant in a class of borrowers with a similar probability of serious delinquency or default over the life of the loan. Loans are then priced based on that classification. Even if underwriting predicts that a borrower has a relatively high level of risk, most of the borrowers in that class will still pay the loan on time and without difficulty. This leads to some suggesting that the borrowers who did repay "should" have been placed in a better risk class and paid less for their mortgage. Wasn't the underwriting wrong since the borrower in fact repaid? This approach based on hindsight misses what underwriting really is: A prediction of what level of risk the borrower has of the occurrence of very low levels of adverse events that nonetheless 16

17 sharply increase lending costs. Just as with automobile liability insurance, the insurer may predict that a particular driver has a high risk of major accident, and place the borrower in a high premium group. If the driver avoids serious accident, it does not follow that the insurer's decision was wrong. The insurer expects that most drivers in that group will not have an accident. But in order to be fair to safe drivers and not force them to pay for the accidents of high risk drivers, the high risk drivers are placed in a special class an pay higher premiums. Subprime lending is similar. Discussion of Results. Chart 10 presents the delinquency, commencement of foreclosure and completion of foreclosure experience for Texas subprime loans. We used delinquencies of 60 or more days for this purpose, since it is recognized in the industry that a delinquency of that length is very serious. Loans that are reported to be in foreclosure as of March 31, 2002 include loans for which foreclosure was started in that month, as well as all loans with foreclosures pending. The third variable tracked is the completion of foreclosure. This event marks the end of the borrower's ownership of the property as well as significant costs and potential losses for the lender. It tracks all foreclosures that have been completed during the whole study period from July 1, 1995 to March 31, As a result, the number of completed foreclosures will in some instances exceed the number of foreclosures reported as "started" and pending as of the reporting date of March 31, The same is theoretically possible with regard to reports of 60 plus days delinquent. The "completed foreclosures" category captures the number of foreclosures that have occurred over the life of the pool of loans being tracked. Nationally, that is from mid-1995 to early 2002, or more than 6 3/4 years. In Texas, because of the newness of the home equity market there, the period is really only 4 1/4 years. Chart 10: Texas Subprime Mortgage Loans: Distribution of Loans in Delinquency and Foreclosure by Price Category 2.00% 1.50% 1.00% 60+ foreclosure started foreclosure complete 0.50% < >7 As is apparent from Chart 10, indicators of repayment difficulty generally track closely the pricing on the loan, confirming that the original pricing on the loans was correct and what we would expect in an efficient market which appropriately charges higher risk borrowers higher prices. High priced loans have by a considerable margin the worst 17

18 delinquency and foreclosure experience. Low priced loans have a significantly better experience. 17 Chart 11 presents national delinquency and default experience in relation to price. As in Texas, it is clear that price closely correlates with delinquency and foreclosure experience nationally. Most of the collection problems occur in the higher priced loans, which is presumably why they were priced higher. Interestingly, foreclosure completion is somewhat lower nationally than in Texas, but serious delinquency runs at higher levels nationally. The differences are not large, and may reflect differences in legal structure in Texas 18, the relative newness of the Texas market, or a relatively higher risk level in Texas flowing from factors we have suggested (but have not established) might be the lower overall value of houses there, or other factors like relative job security for subprime borrowers, or regional economic or cultural conditions. Chart 11: Distribution of Delinquency and Foreclosure Nationally in Subprime Mortgages, by Price Category percent all loans 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 60+ foreclosure started foreclosure complete < >7 Despite the fact that the evidence that price and risk are closely correlated appears to be overwhelming, some may remain suspicious about the category of borrowers who have FICO scores that are above prime or near prime, particularly first mortgage borrowers. It is clear that some of these borrowers are charged significantly elevated prices for their loans. Are they properly placed in the high priced category or could they really qualify for a prime first mortgage at lower rates? It must be remembered that a FICO score only tracks a borrower's credit repayment history. Other factors may make a lender concerned about the borrower's qualification for a prime loan. For example, there may be job instability issues, or the borrower may be carrying a heavy 17 The percentages shown in the chart are derived by taking the number of delinquency, or foreclosure events reported for each price category and dividing by the sum of all loans in all pricing categories. Thus the total delinquency/foreclosure experience in the portfolio is the sum of the percents shown for each price category. This method of calculating the percents provides a good method of comparing results between categories. To determine the delinquency/foreclosure experience of a particular price category, the number of events in that category would be divided by the number of loans in the category. 18 The foreclosure process in Texas is quite rapid compared to many other states, which may reduce the Texas statistics on pending foreclosures relative to national figures. 18

19 debt load. The house may not be worth very much in relation to the size of the loan sought, or the borrower may have a number of other issues which become apparent in the credit application process which the lender finds makes the borrower unacceptable for prime credit. These factors are not captured in the FICO score. Thus it is not particularly surprising that some borrowers have good FICO scores, but also have other credit problems that disqualify them for prime first mortgage credit. The question remains whether they are properly charged for the credit they receive. To examine this issue, we again correlated delinquency and default experience with price for first mortgages, but this time only for borrowers with prime or near prime FICO scores. We selected borrowers with FICO scores over 640 as the prime/near prime category. As noted earlier, a FICO score of 680 or more is usually thought of, absent other factors, as a score that leads to classification as prime. One question was whether there was evidence that "other factors" were present. Chart 12 shows the results for Texas first mortgage borrowers with FICO scores over 640. Once again, price and foreclosure experience are closely correlated. Low priced loans have low delinquency and foreclosure experience relative to high priced loans, and high priced loans have high delinquency and foreclosure experience. The overall levels of loss remain lower than for all subprime loans, but still significantly higher than for prime loans, as will shortly be discussed. Chart 12: Texas Subprime First Mortgages with FICO Scores of 640+: Delinquency and Foreclosure by Price Category 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% < >7 60+ foreclosure started foreclosure complete Chart 13 presents the results nationally. Once again, price and foreclosures are closely correlated, with serious delinquency being a major factor even in lower priced loans. Overall, nationally the levels of activity are slightly lower than in Texas. In part, this may be only because of differences in time. Nationally, we have data on loans going back to 1995, while virtually all of the Texas loans were originated from 1998 forward. As a result, the national portfolio has significantly more older loans in it. Older or "seasoned" loans often perform better than newer loans. As mentioned earlier, there also may be differences between Texas and the national market based on economics, cultural and other factors. 19

20 Chart 13: National Subprime First Mortgages with FICO Scores 640+: Delinquency and Foreclosure by Price Category foreclosure started foreclosure completed < >7 Another category of borrowers that may raise concern are those whose loans are priced below 4 percentage points over Treasuries. Aren't they really prime borrowers? It is likely that some actually receive prime loan pricing from subprime lenders, although there is little agreement about what prime pricing is. Some claim that it is no more than 2 percentage points over Treasuries, while others view anything up to 4 percentage points over Treasuries as prime. Nonetheless, the question arises whether these borrowers, which the previous charts show have the lowest delinquency and foreclosure experience of the subprime borrowers studied, should be viewed as prime borrowers. To examine this question, we compared the 60 plus day delinquency and pending foreclosure rates reported for loans with prices of 4 percentage points over Treasuries or less with comparable Mortgage Bankers Association ("MBA") statistics for "conventional" loans for the same quarter of 2002, which was the first quarter of that year. For these purposes, conventional loans are prime loans. In the National Delinquency Survey, the MBA tabulates each calendar quarter the current delinquency and foreclosure experience nationally and by state. This widely used database provides a point of comparison for the delinquency and default experience in subprime lending, particularly in the "near prime" category of subprime loans priced under 4 percentage points over Treasuries. Chart 14 presents the results nationally. 19 As is apparent, even in this relatively low priced category, subprime loans as a group have significant repayment difficulty in comparison to prime loans under equivalent circumstances. 19 For these purposes, delinquency and foreclosure rates are calculated for subprime loans by dividing the number of events by the number of loans in the category. This provides a rate which is comparable to how MBA calculates the rates of delinquency and pending foreclosures in its National Delinquency Survey. 20