Subprime Markets, the Role of GSEs, and Risk-Based Pricing

Subprime lenders offer mortgages to people who represent a higher level of risk than borrowers who meet standard prime underwriting guidelines. Despite recent growth in the subprime market, little is known about subprime borrowers, their default experiences, or subprime lenders' underwriting practices. A new HUD report, "Subprime Markets, the Role of GSEs, and Risk-Based Pricing," examines lending practices in the subprime mortgage market and the role of the Government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. The report provides a preliminary picture of the potential effects of a larger GSE role in the subprime market based on a literature review and on the opinions and perceptions of key industry participants. In addition to examining whether GSEs bring greater efficiency to the subprime mortgage market and recommending a monitoring role for HUD, the authors explore the impact of risk-based pricing and automated underwriting systems on the mortgage lending environment.

GSEs Increase Their Subprime Lending Business
The market's current liquidity is overwhelmingly provided by affiliates of depository lenders and Wall Street investment banks that issue private-label mortgage backed securities. The GSEs are increasing their subprime lending business in part due to higher affordable housing goals set by HUD's October 2000 regulation. The rule identifies subprime borrowers as a market that can help Fannie Mae and Freddie Mac meet their goals and help to increase standardization in the subprime market. GSEs currently purchase only about 14 percent of subprime loans, but market analysts expect that in the next few years the GSEs could purchase as much as 50 percent of the overall subprime mortgage volume.

Industry Perception
Seven lending companies and representatives of eleven other organizations, including consumer groups, regulators, investment banks, and trade associations, were interviewed for the report. Interviews revealed that some subprime market participants believe Fannie Mae and Freddie Mac should not increase their status as GSEs because it would create an unfair competitive advantage. All consumer groups, regulators, and market analysts favored cautious subprime market entry by the GSEs, because they thought such a move would benefit consumers through cheaper loan prices and more standardization.

HUD's Role
The report recommends that HUD assess whether or not GSE subprime mortgage products are penetrating the market and creating cheaper loans for different types of borrowers by comparing

• The types of subprime loans purchased by the GSEs relative to all subprime mortgages originated.
• The prices of agency and non-agency subprime loans.
• The income of borrowers receiving agency subprime loans versus non-agency subprime loans.
• The proportion of agency to non-agency subprime loans originated by prime lenders.

Other recommended activities for HUD include:

• Monitoring subprime lending to ensure that the GSE's underwriting and appraisal guidelines comply with fair lending laws.
• Assessing whether a larger GSE role will improve efficiency and fairness.
  
• Examining whether the systems have a disproportionate effect on minority borrowers by categorizing them into higher risk grades.
  
• Exploring whether new automated underwriting systems have a disproportionate effect on minority borrowers by categorizing them into higher risk grades and whether any factors that have a disproportionate effect serve a business necessity.
• Evaluating the need to review the appropriateness of a larger GSE subprime role within the procedural framework established in the Federal Housing Enterprises Financial Safety and Soundness Act of 1992.

"Subprime Markets, the Role of GSEs, and Risk-Based Pricing" is available for $5.00 from HUD USER. Please use the order form. You can also download it from the HUD USER Web site at www.huduser.gov.