The growth of subprime mortgage lending is one indication of the extent to which access to credit has increased for all households, including those with lower incomes...

Although the emergence of risk-based pricing has increased access to credit for all households, it has also raised some concerns and questions, which are magnified in the case of lower-income borrowers.

At present, mortgage delinquencies remain low, although delinquencies on subprime mortgages have risen in recent months. The recent rise in subprime mortgage delinquencies has been concentrated among adjustable-rate subprime loans, which is probably related to interest rates resetting--as the first reset tends to occur much earlier for subprime ARMs than prime ARMs. The outlook for mortgage credit quality remains favorable, but modestly cautionary signs are on the horizon. We have had clear initial signals in recent months that housing prices are no longer rising as they had been and are declining modestly in some key markets. Growth in housing wealth may slow or stagnate while the debt service obligation continues to rise, as teaser rates expire and fully-indexed loan rates eventually catch up with increases in market rates. While we continue to expect that mortgage delinquencies will remain manageable, lenders should closely monitor future developments.

Finally, instruments such as sub-prime mortgages, interest-only loans, and hybrid ARMs have opened up financing to borrowers who previously could not obtain it at all or could not borrow as much as they would like. True, these instruments are riskier than traditional mortgages. Still, to the extent that both borrowers and lenders understand the risks involved and markets have priced this risk properly, they represent a net gain to society. Here, there is a role for public policy: On the part of the Fed, we are promoting financial literacy efforts for borrowers and supervising lenders with regard to both the disclosure of terms and costs to borrowers and to the risks of carrying such non-standard loans on their books.

The enhanced ability of lenders to assess credit risk gave rise to a segment of the mortgage market often referred to as subprime lending.  In the subprime market, higher-risk borrowers pay higher prices.  Subprime lending has grown rapidly, from less than 5 percent of all mortgage lending in 1994 to an estimated 20 percent in 2005, or over $600 billion.  The wider range of loan pricing available in the subprime market helped to expand consumers’ homeownership opportunities and to increase their access to home equity.  But this same price variability has raised concerns about unequal treatment of borrowers.  It also has raised concerns about whether certain loan terms and lending practices are appropriate, whether consumers have the ability and knowledge to shop for the most beneficial loan terms, and whether the subprime market is sufficiently competitive.

The Board responded to these concerns by amending Regulation C, the regulation that implements HMDA, to expand the available data on higher-priced lending.  The data released by the FFIEC in September 2005, which covered lending activity in 2004, contained the first loan-level information on loan pricing ever available to the general public.  The data contain price information for loans whose prices exceeded thresholds set by the Board.  The thresholds were selected to target segments of the home loan market that have raised the most concern, taking into consideration the cost and burden of reporting.  The thresholds generally correspond to an unofficial line separating the prime and subprime markets.  But that line of separation is not always clear, and its correspondence with the reporting thresholds is in any event imprecise.  Therefore, we call loans whose prices exceed the reporting threshold "higher-priced loans" rather than "subprime loans."

Mortgages with some of the characteristics of nontraditional mortgage products have been available for many years; however, they have historically been offered to higher-income borrowers. More recently, they have been offered to a wider spectrum of consumers, including subprime borrowers, who may be less suited for these types of mortgages and may not fully recognize the embedded risks. These borrowers are more likely to experience an unmanageable payment shock during the life of the loan, meaning that they may be more likely to default on the loan. Further, nontraditional mortgage loans are becoming more prevalent in the subprime market at the same time risk tolerances in the capital markets have increased. Banks need to be prepared for the resulting impact on liquidity and pricing if and when risk spreads return to more "normal" levels and competition in the mortgage banking industry intensifies.

Lenders should recognize that certain nontraditional mortgage loans are untested in a stressed environment; for instance, nontraditional mortgage loans to investors that rely on collateral values could be particularly affected by a housing price decline. Investors have represented an unusually large share of home purchases in the last two years. Past loan performance indicated that investors are more likely to default on a loan when housing prices decline, than owner occupants.

Nontraditional mortgage products have been available for many years; however, these types of mortgages were historically offered to higher-income borrowers only. More recently, these products have been offered to a wider spectrum of consumers, including subprime borrowers who may be less suited for these types of mortgages and may not fully recognize their embedded risks.

Predatory lending is a serious problem that needs to be addressed in a way that preserves incentives for responsible subprime lenders so that worthy borrowers with imperfect credit can become homeowners. Constricting the market by pinpointing what might be considered predatory lending and returning to a situation where some borrowers have very limited access to credit is not an ideal solution. We want to encourage, not limit, mortgage lending by responsible lenders in low- and moderate-income markets.

Rising debt-to-income ratios can be somewhat misleading as an indicator of stress. Indeed the ratio of household debt to income has been rising sporadically for more than a half-century, a trend that partly reflects the increased capacity of ever-wealthier households to service debt. Moreover, a significant part of the recent rise in the debt-to-income ratio reflects the remarkable gain in homeownership...Thus, short of a period of appreciable overall economic weakness, households, with the exception of some highly leveraged subprime borrowers, do not appear to be faced with significant financial strain.

One of the key financial developments of the 1990s was the emergence and rapid growth of subprime mortgage lending... The increased availability of subprime mortgage credit has created new opportunities for homeownership and has allowed previously credit-constrained homeowners to borrow against the equity in their homes to meet a variety of needs. At the same time, increased subprime lending has been associated with higher levels of delinquency, foreclosure, and, in some cases, abusive lending practices. On a social level, one question is whether the gains afforded by these new market developments outweigh the losses. Another question is whether anything can be done to limit foreclosures. These are my topics today.

What then about the rise in bankruptcy rates and similar indicators?  Bankruptcy rates are hard to forecast, as they vary over time with changes in law and financial practice; moreover, they themselves do not tend to forecast broad economic conditions very well. One partial explanation for their recent increase, as I intimated earlier, may be the expansion earlier in the decade of the so-called subprime lending market, in which lenders sought to make loans to households whose credit histories excluded them from the mainstream market.  Although some legitimate concerns have been raised about lending abuses in this market, overall the expansion of the subprime market is a positive development, opening up as it does new opportunities for borrowers previously excluded from credit markets.  Not unexpectedly, however, lenders, borrowers, and regulators have faced a significant learning curve as this market has developed, and perhaps we should not be surprised that some of the loans made in this market in a period of strong economic growth have become distressed in a period of recession and rising unemployment.

Banks that have not understood the subprime market have had significant difficulties. To ensure that banks entering this business properly understand these risks, the agencies have encouraged banks to adopt strong risk management systems tailored to the challenges posed by these loan segments. Beyond poor risk management, there have also been instances in which certain lenders have charged fees and structured loans designed not to protect against risk, but rather to deceptively extract a borrower's net worth. Such predatory lending practices, though rare, are a cause for concern and examiners are watchful for programs that would violate the law in this regard.

From staff appendix to the Chairman's testimony

Recently a number of housing and banking agencies, including the Federal Reserve, have announced their intention to study possible restrictions on predatory lending. The Department of Housing and Urban Development (HUD) has set up a national task force on the topic. Members of Congress on both sides of the aisle have bills that limit predatory practices.

The ultimate difference between subprime and predatory lending comes back to the competitive assumptions. If one is a market optimist and believes that both lenders and borrowers are rational and well-informed, then subprime credit markets with proper rate differentials will open up. If one is a market pessimist and believes that borrowers are not well-informed and may not be fully rational, then some lenders will have opportunities to exploit these borrowers with predatory practices. Distinguishing positive subprime lending from negative predatory lending is obviously important, particularly for regulators trying to encourage one type of lending and discourage the other.

The drive to stretch traditional underwriting criteria is intensifying. Recently, there has been a boom in so-called "subprime" lending, offering a variety of types of mortgage and other loans to borrowers who have less than good credit; such lending is priced for risk and the favorable pricing of securities backed by subprime loans have found acceptance with investors...

Improved access to credit for consumers, and especially these more recent developments, reflects a good news/bad news story. The good news is that market specialization, competition, and innovation have vastly expanded credit availability to virtually all income classes. Access to credit is essential to help families purchase homes, deal with emergencies, and obtain goods and services that have become staples of our daily lives. Home ownership is at an all-time high, and the number of home mortgage loans to low- and moderate-income families has risen at a rapid rate over the last 5 years. Credit cards and installment loans are available to the vast majority of households.

The bad news is that under certain circumstances this may not be entirely good news, either for consumers in general or for lower-income communities. Along with unprecedented credit access, some problems are occurring that should alert us all to potential dangers. While every potential problem doesn't result in disaster, it's important to recognize the risks and take protective steps.

Some loans to low- and moderate-income families with multiple underwriting flexibilities, layered subsidies, and high loan-to-value ratios have been showing unfavorable delinquency and default trends. Large mortgage lenders, secondary market agencies, and private mortgage insurers are conducting studies of their portfolios to determine how more-relaxed underwriting standards are affecting delinquencies and defaults. Although more study is required to determine which risk factors are most important in particular lending situations, the results of these portfolio studies bear watching.

Although legitimate lenders may be able to manage the risks associated with the overall expansion of lending, the same may not be true of many consumers, especially those with limited means to weather a storm or who have been encouraged to borrow improvidently. Should economic or personal difficulties occur, such as the temporary loss of a job, illness, or unexpected car or house repairs, those with limited incomes and without significant savings may easily find themselves in financial trouble.