The record-breaking number of home foreclosures in recent years has prompted calls to ban subprime mortgage financial instruments. But there are a variety of types of subprime loans, and not all may be associated with higher default rates.

A 2011 study from the George Mason University, Pennsylvania State University and the National University of Singapore, “Thy Neighbor’s Mortgage: Does Living in a Subprime Neighborhood Affect One’s Probability of Default?”  analyzes 461,729 subprime and traditional mortgages originated between 2000 and 2007 in Maricopa County, Arizona.

The study, published in Real Estate Economics, makes a key distinction between traditional adjustable rate mortgages (ARMs), where the interest rate is periodically modified, and hybrid-ARMs, in which there is a fixed rate for an initial number of years (sometimes called a “teaser” rate) but then the rate rises, sometimes dramatically. During the housing bubble, many hybrid-ARMs were based on high loan-to-value ratios, as parties assumed housing prices would rise rapidly.

Key study findings include:

• As the number of subprime mortgages in metropolitan Phoenix rose from approximately 11,000 in 2000 to a peak of 145,000 in 2005, home values in the area more than doubled — and mortgage defaults jumped from about 20,000 in 2004 to 150,000 in 2006.
• A 1% increase in foreclosed homes within a given ZIP code was associated with a 2.9% increase in area mortgage default rates. A 1% increase in the geographic concentration of hybrid-ARMs was associated with a nearly 3% increase in local default rates.
• However, “after controlling for individual borrower risk characteristics and foreclosures in the area, the concentration of subprime lending in the neighborhood does not increase the risk of borrower default…. It does not appear that extending credit to subprime borrowers in general increased the probability of borrower default.”
• Though “much discussion in the popular press has blamed the use of ARMs for the current default crisis,” it was the “higher concentrations of the more aggressive mortgage products (hybrid-ARMs and no- or low-documentation loans)” that were linked with higher rates of borrower default.
• At the individual level, “borrowers that originated loans with either low or no documentation are 1.8 and 2.4 times more likely to default than borrowers that provide documentation of their incomes and assets.” The presence of prepayment penalties (which can make refinancing difficult) increases the odds of default for a borrower by 12.6%.
• Areas with lower levels of subprime loan activity experienced less housing stock appreciation between 2000 and 2007; conversely, areas with the highest levels of subprime loan activity saw prices significantly increase for lower-priced housing stock between 2003 and 2004. “Subprime origination activity is correlated with house price appreciation, suggesting that access to credit played a role in fueling the housing bubble in Phoenix.”
• The percentage of borrowers in Maricopa County who provided minimal or no income documentation increased from 24% in 2000 to 58% in 2007. The percentage of fixed-rate mortgages (FRMs) declined from 50% of all loans in 2000 to 34% in 2004, while the percentage of adjustable-rate mortgages (ARMs) rose from 46% in 2000 to 65% in 2004.

The researchers conclude that subprime lending was not always the root cause of systemic housing market problems, but rather certain riskier types of such lending: “This finding is important given the current policy debates concerning the role of subprime lending and the formation and burst of the housing bubble.”

Tags: consumer affairs, economy, municipal