Subprime Mortgages Didn't Necessarily Lead to More Homeowners: St. Louis Fed Analysis

/PRNewswire/ -- Proponents of subprime mortgages argued that this type of financing could encourage homeownership for people who otherwise couldn't afford to buy a house, but a recent analysis from the Federal Reserve Bank of St. Louis suggests that the number of subprime mortgage loans terminated between 2001 and 2006 outweighed the number of estimated first-time homebuyers who sought subprime mortgages.

The analysis appears in the March/April issue of Review, the St. Louis Fed's bi-monthly journal of economic and business issues, and was conducted by Yuliya S. Demyanyk, a senior research economist with the Federal Reserve Bank of Cleveland. The data analysis for this article was conducted when she was an economist in the Banking Supervision and Regulation Division of the Federal Reserve Bank of St. Louis.

Demyanyk focused on whether borrowers intended to keep their subprime mortgages long enough to substantiate an increase in homeownership or planned a quick exit strategy at origination, using subprime loans as bridge financing to speculate on house prices -- in other words, quickly sell the house for profit after its value increased.

Her research showed that loans originated between 2001 and 2006 generally lasted less than three years. In fact, almost half the loans exited the market either through pre-payment or default within the first two years of origination and about 80 percent did so within three years of origination.

Demyanyk said her results are consistent with an earlier study that showed the unusually high default rates among loans originated in immediate pre-crisis years (2006 and 2007) did not occur only months from origination because those subprime mortgages were much worse than all loans that originated earlier. The quality of loans was deteriorating for at least six consecutive years before the crisis occurred.

"Subprime mortgages were very risky all along," she said. "The extent of their risk, however, was hidden by the rapid appreciation in house prices, allowing termination of the mortgage by refinancing or pre-payment. When pre-payment became costly -- with zero or negative equity in the house increasing the closing costs of refinancing -- defaults took their place."

The number of defaults in the limited sample of subprime purchase-money mortgages within two years of origination is almost equal to the number of first-time homebuyers who took a subprime mortgage. "If the data for the rest of the market were available," said Demyanyk, "the number of defaults would no doubt be even greater."

Demyanyk's paper is available online at the St. Louis Fed's web site: http://research.stlouisfed.org/publications/review.

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