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Policy incentives and the extension of mortgage credit: Increasing market discipline for subprime lending

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  • Xudong An

    (Assistant Professor, Department of Finance, College of Business Administration, San Diego State University)

  • Raphael W. Bostic

    (Professor, School of Policy, Planning, and Development and the Lusk Center for Real Estate, University of Southern California)

Abstract

The lax underwriting in non-prime mortgage markets is widely perceived as one cause of the recent difficulties in the housing market. Policymakers are currently considering moves such as enforcing more careful underwriting to provide additional discipline to mortgage markets. This research explores the possibility of another approach to supplement or replace some of these efforts, namely the use of policy to create incentives for Fannie Mae and Freddie Mac (together, the GSEs) to help “check” behavior in non-prime markets. The hypothesis is that the GSE Act affordable housing goals have increased GSE focus on targeted loan purchases, which in turn has led prime market lenders to compete more aggressively for borrowers on the margin between prime and subprime credit quality. As a consequence, these marginal borrowers will be more inclined to take prime mortgages rather than higher-cost subprime loans. We test this hypothesis and find empirical support for it. We observe a negative relationship between the growth in GSE market share and the growth in subprime market share over time, and find that the impact of the GSEs on subprime lending tends to be stronger in high-minority neighborhoods, where subprime lending has been concentrated and growing the fastest. Simulations show that a 10 percent increase in GSE market share (for example, from 20 to 22 percent) can cause 45,000 borrowers using prime instead of subprime loans a cost savings of about $1.7 billion. These results suggest that the GSEs, regardless of their postconservatorship form, should continue to devote attention to serving underserved populations and suggest that significant welfare benefits will accrue. © 2009 by the Association for Public Policy Analysis and Management.

Suggested Citation

  • Xudong An & Raphael W. Bostic, 2009. "Policy incentives and the extension of mortgage credit: Increasing market discipline for subprime lending," Journal of Policy Analysis and Management, John Wiley & Sons, Ltd., vol. 28(3), pages 340-365.
    • Handle: RePEc:wly:jpamgt:v:28:y:2009:i:3:p:340-365
    DOI: 10.1002/pam.20436
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    References listed on IDEAS

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    1. Bostic, Raphael W. & Gabriel, Stuart A., 2006. "Do the GSEs matter to low-income housing markets? An assessment of the effects of the GSE loan purchase goals on California housing outcomes," Journal of Urban Economics, Elsevier, vol. 59(3), pages 458-475, May.
    2. Marsha J. Courchane & Brian J. Surette & Peter M. Zorn, 2004. "Subprime Borrowers: Mortgage Transitions and Outcomes," The Journal of Real Estate Finance and Economics, Springer, vol. 29(4), pages 365-392, December.
    3. Souphala Chomsisengphet & Anthony Pennington-Cross, 2006. "The evolution of the subprime mortgage market," Review, Federal Reserve Bank of St. Louis, vol. 88(Jan), pages 31-56.
    4. Jonathan Hershaff & Karl Russo & Susan M. Wachter, 2005. "Subprime lending: neighborhood patterns over time," Proceedings 954, Federal Reserve Bank of Chicago.
    5. Kathleen C. Engel & Patricia A. McCoy, 2001. "The law and economics of remedies of predatory lending," Proceedings 790, Federal Reserve Bank of Chicago.
    6. Brent W. Ambrose & Michael LaCour‐Little & Anthony B. Sanders, 2004. "The Effect of Conforming Loan Status on Mortgage Yield Spreads: A Loan Level Analysis," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 32(4), pages 541-569, December.
    7. Ambrose, Brent W. & Thibodeau, Thomas G., 2004. "Have the GSE affordable housing goals increased the supply of mortgage credit?," Regional Science and Urban Economics, Elsevier, vol. 34(3), pages 263-273, May.
    8. Keith D. Harvey & Peter J. Nigro, 2004. "Do Predatory Lending Laws Influence Mortgage Lending? An Analysis of the North Carolina Predatory Lending Law," The Journal of Real Estate Finance and Economics, Springer, vol. 29(4), pages 435-456, December.
    9. Paul S. Calem & Kevin Gillen & Susan Wachter, 2004. "The Neighborhood Distribution of Subprime Mortgage Lending," The Journal of Real Estate Finance and Economics, Springer, vol. 29(4), pages 393-410, December.
    10. Elizabeth Renuart, 2004. "An overview of the predatory mortgage lending process," Housing Policy Debate, Taylor & Francis Journals, vol. 15(3), pages 467-502.
    11. Joseph Nichols & Anthony Pennington-Cross & Anthony Yezer, 2004. "Borrower Self-Selection, Underwriting Costs, and Subprime Mortgage Credit Supply," The Journal of Real Estate Finance and Economics, Springer, vol. 30(2), pages 197-219, November.
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    Cited by:

    1. Dwight Jaffee & John M. Quigley, 2012. "The Future of the Government-Sponsored Enterprises: The Role for Government in the U.S. Mortgage Market," NBER Chapters, in: Housing and the Financial Crisis, pages 361-417, National Bureau of Economic Research, Inc.
    2. Levitin, Adam & Wachter, Susan, 2012. "Explaining the Housing Bubble," MPRA Paper 41920, University Library of Munich, Germany.
    3. Ashlyn Aiko Nelson, 2010. "Credit scores, race, and residential sorting," Journal of Policy Analysis and Management, John Wiley & Sons, Ltd., vol. 29(1), pages 39-68.
    4. Jonathan Spader & Roberto Quercia, 2012. "CRA Lending in a Changing Context: Evidence of Interaction with FHA and Subprime Originations," The Journal of Real Estate Finance and Economics, Springer, vol. 44(4), pages 505-525, May.

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