FRBSF Economic Letter
2007-14; June 8, 2007
House Prices and Subprime Mortgage Delinquencies
The recent sharp increase in subprime mortgage delinquencies
has captured the public spotlight and led analysts to search
for the factors that are likely to have contributed to
the problem. These factors commonly include the lack of
income documentation, high loan-to-income ratios, the lowering
of credit standards, and the resets on adjustable-rate
loans, to name but a few. Although these factors are important
to consider, it also is important to remember that the
delinquencies have occurred during a time of seismic shifts
in the patterns of house-price appreciation, shifts that
were unprecedented in terms of their size and suddenness
and that varied widely across metropolitan areas.
In this Letter, we explore how the pace of and change
in house-price appreciation can affect the incentives and
opportunities for borrowers in a market to avoid delinquencies
and foreclosures. For instance, with likely gains in
home
equity in markets where house prices have risen significantly,
a homeowner should have greater incentives and opportunities
to keep a mortgage loan current. Indeed, we show that
markets that recently experienced greater house-price appreciation
tended to have lower delinquency rates and smaller increases
in delinquency rates. We also find that metropolitan
areas
where house prices decelerated the most in 2006 have
experienced the largest increases in subprime delinquency
rates. One
of several possible explanations for this relationship
is that, in the face of sharp declines in the pace of
house-price appreciation, some borrowers may have lowered
their expectations
about future appreciation rates, and, hence, the attractiveness
of the investment component of homeownership also declined.
The subprime market
One hurdle facing researchers in the subprime market
area is that there is no readily agreed upon definition
of "subprime." Indeed,
the subprime residential mortgage market barely existed
in 1995, although since then it has grown rapidly, by some
estimates accounting for approximately 20% of all first
lien mortgages made in 2006. Generally speaking, subprime
is a lender-given designation for borrowers with low credit
scores (FICO score less than 620, for example), with little
credit history, or with other types of observable credit
impairment.
Although "subprime" is not rigorously and consistently
defined in the mortgage industry, one firm, First American
LoanPerformance (FALP), has produced a number of statistics
on regional delinquency rates based on subprime mortgages
in its database. The delinquency rate is defined as the
percent of subprime loans that are delinquent 60 days or
more. The data, which are from 2005 and 2006, contain observations
on 309 metropolitan statistical areas (MSAs), and form
the basis of our analysis (see also The Wall Street
Journal 2007). It is worth noting that the FALP data do not represent
the entire universe of mortgages; also, estimates of delinquency
rates on subprime mortgages vary among sources, reflecting
differences in the definition of subprime and sample coverage.
However, where possible, we have compared the FALP data
to those from other sources and have found high correlations
among them.
The FALP data show considerable regional variation in
the delinquency rates and in the changes in the delinquency
rates. The median delinquency rate in 2006 among the
309
MSAs was 12.2%, with a range from about 3% to 25%. MSAs
near the Gulf Coast that were severely affected by Hurricane
Katrina were among those with the highest delinquency
rates. Overall, however, the MSAs with the highest delinquency
rates tend to be located in the Midwest; of the 18 MSAs
with the highest subprime delinquency rates in 2006,
14
were in Michigan or Ohio.
In terms of changes in subprime delinquency rates, nearly
all MSAs posted increases from 2005 to 2006. The median
change was about 3 percentage points, and the largest
increase was 11 percentage points. Of the 309 MSAs in the
sample,
only 25 had decreases in their delinquency rates, with
the sharpest declines among MSAs near the Gulf Coast.
Of the 18 MSAs that posted the largest increases in delinquency
rates, 12 were in California and 3 were in Massachusetts.
These MSAs typically had relatively low delinquency rates
at the end of 2005.
Delinquency rates in 2006 and recent house-price appreciation
There are a number of possible reasons for the observed
differences in subprime delinquency rates among MSAs
in 2006, including variation in economic conditions, differences
in the riskiness of the subprime borrower pools across
MSAs, and changes in the house prices. Parsing out the
relative importance of these reasons involves a degree
of complication that is beyond the scope of this Letter.
With that said, we examine the relationship between house-price
appreciation and delinquency rates for subprime mortgages
among MSAs. Specifically, we compare the share of subprime
mortgages in delinquency at the end of 2006 and the percent
change in house prices, as measured by the Office of
Federal Housing Enterprise Oversight (OFHEO) indexes, from
2004
through 2006. For this period, the pace of house-price
appreciation varied considerably. For the sample of 309
MSAs, appreciation rates ranged from -2% in Kokomo, Indiana,
to almost 54% in the Phoenix, Arizona, area.
 Figure 1 provides a graphical perspective on the link
between delinquency rates and house-price appreciation.
The figure
covers the largest 150 MSAs in the sample. Excluded from
the figure are several MSAs near the Gulf Coast that
were severely affected by Hurricane Katrina. The figure
shows
a very strong negative correlation between recent rates
of house-price appreciation and the level of the subprime
delinquency rate in 2006 (the correlation coefficient
is 0.79); that is, higher rates of house-price appreciation
are associated with lower rates of delinquencies.
This negative correlation could arise for a variety of
reasons. One possibility is that the economies in MSAs
with rapidly appreciating house prices were strong, and,
hence, relatively fewer households became delinquent
in their payments. However, we find that controlling for
economic
conditions (as measured by employment growth and the
unemployment rate) does little to alter the relationship
displayed in
Figure 1.
Another possibility is that distressed borrowers in strong
housing markets have opportunities to pursue alternatives
to delinquency. For instance, a homeowner in a market
with rapid house-price appreciation is likely to have built
up more home equity than a homeowner in a market with
smaller
gains in house prices. With higher home equity, homeowners
have a greater incentive to keep their mortgage loans
current. Further, homeowners with a greater equity stake
would be
in a better position either to sell their homes and pay
back the remaining principal or to refinance existing
mortgages to ones that would offer lower, more affordable
payments,
at least for a while.
Changes in delinquency rates
We also find that changes in delinquency rates on subprime
residential mortgages were strongly related to changes in the pace of house-price appreciation. In the analysis
we looked at the changes in the subprime delinquency
rates from 2005 to 2006 and the changes in house-price
appreciation
rates in 2006 compared to 2005. An MSA experiencing a
deceleration in house prices would have a negative change
in its appreciation
rate. For the overall sample, changes in appreciation
rates ranged from about -32% (deceleration) in the Cape
Coral-Fort
Myers, Florida, areas to over 11% (acceleration) in Lawton,
Oklahoma.
 Figure
2 plots the pairings of changes in mortgage delinquency
rates and changes in house-price appreciation for the
largest 150 MSAs in the sample. A negative value on the
vertical axis implies
that house prices in 2006 grew less quickly than house
prices in 2005—that is, a deceleration in house prices.
As the figure shows, MSAs that experienced large decelerations
in prices tended to experience large increases in rates
of subprime mortgage delinquencies (the correlation is
0.61).
In addition to the simple correlation illustrated in
the figure, we used a variety of techniques to examine
the
empirical relationship. For example, we took into account
differences in the pace of house-price appreciation among
the MSAs in 2006, to control for the possibility that
areas experiencing large decelerations in house prices
were simply
ones with low rates of appreciation in 2006. While we
found evidence that low rates of appreciation were associated
with large changes in delinquency rates, we still found
a strong and highly statistically significant relationship
between increases in the delinquency rates and house-price
deceleration. We also found that the relationship holds
up when we control for changes in economic conditions
in
housing markets.
The finding that changes in delinquencies are related
to house-price deceleration raises the possibility that
the
increases in delinquencies reflect not just borrower
distress but also a decline in the demand for housing.
This might
be true if some borrowers originally were willing to
spend more on their mortgages than they otherwise would
because
they expected large gains in equity from future house-price
appreciation. When those gains did not materialize, some
borrowers may have reassessed their expectations about
future appreciation rates and thus their decisions about
spending on housing.
Such an effect from changes in expectations about future
house-price appreciation would be expected to affect
the demand for housing more generally, not just subprime
borrowers.
Indeed, the data on home sales and surveys on the demand
for home mortgages indicate a general decline in demand
for buying homes. In addition, while delinquency rates
on prime mortgage loans remain quite low, the MSA-based
data show a positive correlation between changes in delinquency
rates on subprime and prime mortgages.
It also is possible that the patterns of house-price
appreciation are linked to delinquency rates through their
influence
on mortgage lenders' assessments of risk. For example,
MSAs that had large decelerations in house prices also
had very high rates of house-price appreciation prior
to 2006. The earlier rapid rates of appreciation may have
paved the way for new, riskier borrowers to enter the
market,
as lenders were more willing to finance house purchases
in markets with rising prices. However, in this case,
the eventual rise in delinquencies would have been due
to the
previous high rates of house-price appreciation rather
than the subsequent deceleration
Conclusion
The sharp rise in delinquency rates on subprime residential
mortgages has raised concerns about credit underwriting
practices and economic distress among borrowers and has
drawn the attention of policymakers at the Fed and elsewhere.
No doubt, this is a complex issue, influenced by a number
of different dynamics. Our analysis focuses on one of
the potential dynamics, and we find that differences in
the
performance of subprime mortgages among MSAs may reflect
in part the effects of house-price appreciation on the
incentives and the opportunities of some mortgage borrowers
to keep loans current. Two of the potential channels
through which house-price appreciation may affect the subprime
delinquency rate that we suggest are the incentive to
protect
home equity associated with recent appreciation in house
prices and the effect of changes in expectations about
future house-price appreciation on the demand for housing. Mark Doms
Senior Economist
Frederick Furlong
Group Vice President
John Krainer
Economist
Reference
[URL accessed June 2007.]
Wall Street Journal (online edition). 2007. "Where
Subprime Delinquencies Are Getting Worse." (March
29)
[subscription required].
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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Questions? Contact
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