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Subprime Still Essential

Subprime Still EssentialBies, Moskow speak about problem sector

February 22, 2007


Despite recent problems with subprime mortgages, the increase in the number of U.S. homeowners from nonprime lending represents a net gain, according to two recent Federal Reserve speeches.

Some mortgage lenders, overly anxious to close loans, have gotten borrowers into loans that they know some borrowers cannot afford, charged Federal Reserve Board Governor Susan Bies, referring to adjustable-rate subprime loans.

This new “transaction-based mentality” is driving more borrowers to become delinquent on their mortgages, she said during a talk Tuesday at Duke University’s Fuqua School of Business in which she again targeted subprime mortgages.

While subprime mortgages represent only “a sliver that is 7 to 8% of all outstanding mortgages,” she noted that delinquency rates among some pools of subprime mortgages are as high as 10%, which is much higher than historical averages.

These lenders have relaxed their underwriting standards in order to get borrowers committed to a loan “before they go and shop elsewhere,” she said, noting that consumers too often do not shop for mortgages but rather rely on what is presented to them by a single lender.

photo of Susan Bies
Susan Bies

Lenders need to tighten their underwriting standards, taking into account borrowers’ ability to continue making payments after rates adjust upward, she said in her speech on “Risk Management in Mortgage Markets.”Her criticisms of subprime lending came four days after Federal Reserve Bank of Chicago President and CEO Michael Moskow warned that there is “a risk that defaults on subprime mortgages could have a larger than expected effect on households and lenders.”

As a result of this concern, he said the Fed is “offering guidance to lenders with regard to the disclosure of terms and costs to borrowers and with regard to the risks of carrying such loans on their books.”

However, while Bies said subprime mortgages have become increasingly risky for borrowers with low credit ratings, their flexible terms have helped more Americans become homeowners.

Similarly, Moskow, in his remarks at the University Club of Chicago, said subprime mortgages “represent a net gain to society by opening up financing to borrowers who previously could not obtain it.”

Also on the positive side, Bies said that delinquencies had not become a problem in the prime market. She also said that, although it will “take a while to fully work through” the current inventory of unsold homes, the housing market’s current slump, which may now be “near the floor,” should hit bottom in the second half of this year and begin to recover as jobs and wages grow. Thus, she said, the housing sector should be less of a drag on the economy this year than it was in 2006.

Bies has resigned from the Fed’s Board of Governors effective in March while Moskow has announced that he will be leaving his position in August.

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