Subprime Mortgage Yields

In the Legislative and Litigative Trends section of this issue of Spotlight we review Federal Reserve Governor Edward Gramlich's comments on the economic rationale for subprime mortgage lending. The issue is whether subprime mortgage loans are synonymous with "predatory" mortgage loans and need to be curtailed by government regulation. If subprime loans were predatory, their yields would be more closely related to the race, ethnicity or education of the borrower than to the credit risk represented by the borrower. In a recent issue of the Economic Letter of the Federal Reserve Bank of San Francisco, Elizabeth Laderman empirically addresses the question of whether subprime mortgage loans are "predatory."

Laderman compares the yield on 10-year Treasury bill notes to (1) the average yield on prime mortgages from 1995 through 2001, and (2) from 1998 through 2001 the yield on a securitized portfolio of about $100 billion subprime home mortgage loans. She also compares the yields on subprime mortgage loans to the yield on junk bonds over the period 1998 through 2001.

Her findings are very helpful in appraising the debate about "subprime" and "predatory" residential mortgage loans. First, she found that the interest yields on prime residential mortgages were highly correlated with the yields on 10-year treasury notes. (The correlation ratio was 0.9, while a perfect correlation would have been 1.0.) Thus, the market viewed these two types of investment as having about equal credit risk. Second, over the period from 1998 through 2001, "the subprime mortgage rate exceeded the prime mortgage rate by an average of 3.7 percentage points." Third, she found that the yield on the portfolio of subprime residential mortgages was not highly correlated with the yield on 10-year treasury notes (0.7), but was more highly correlated with the yield on junk bonds. In short, both investments represent a high credit risk.

In summary, her research demonstrates that the difference in the yields on prime and subprime mortgages does not reflect a "predatory" treatment of subprime borrowers, but a reflection of the market's appraisal of the difference in the risk of prime and subprime loans. The risk has two components: (1) the credit risk (i.e. failure to repay according to the terms of the mortgage) and (2) the greater risk of prepayment on subprime mortgage loans.