Policy Incentives and the Extension of Mortgage Credit: Increasing Market Discipline for Subprime Lending

36 Pages Posted: 16 Jun 2008

See all articles by Xudong An

Xudong An

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Raphael W. Bostic

Federal Reserve Bank of Atlanta

Abstract

The lax underwriting in non-prime mortgage markets is widely perceived as one cause of the recent difficulties in the housing market. Policy makers 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. It relies on the hypothesis that the affordable housing goals established through the GSE Act have been effective incentives for GSEs to increase their loan purchases, and that borrowers shift from subprime to prime loans and such a substitution benefit those households receiving prime mortgages rather than the higher cost subprime loans.

We conduct empirical analysis regarding the hypothesis that increased GSE purchase activities make subprime lending less salient. Our results confirm the negative relationship between the growth in GSE market share and the growth in subprime market share over time, and 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 ten percent increase in GSE market share (e.g. from 20% to 22%) can cause 26,000 borrowers using prime instead of subprime loans, at a cost savings of about $1 billion. Our empirical results strongly support the concept that significant efficiency and equity gains can be achieved through appropriate regulatory structure.

Keywords: Subprime lending, government-sponsored enterprise (GSE), affordable housing goals, mortgage credit, cost savings

Suggested Citation

An, Xudong and Bostic, Raphael W., Policy Incentives and the Extension of Mortgage Credit: Increasing Market Discipline for Subprime Lending. Available at SSRN: https://ssrn.com/abstract=1146725 or http://dx.doi.org/10.2139/ssrn.1146725

Xudong An (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Raphael W. Bostic

Federal Reserve Bank of Atlanta

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States

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