Research Bears Out Subprime Pricing.

Mr. Pennington-Cross, a senior economist at the Office of Federal Housing Enterprise Oversight, authored a working paper to address loss distributions between subprime and prime mortgage loans. The following is an excerpt from the working paper, and the full version is available on OFHEO's website (www.ofheo.gov). OFHEO said the conclusions of its working papers are those of the author and do not imply concurrence by other OFHEO staff.

Research has shown that borrowers of subprime mortgages often default more frequently than do borrowers of prime mortgages. In addition, borrowers of subprime mortgages also appear to react differently to changing interest rates and other economic conditions than do other borrowers. Few studies have explored the link between the likelihood of prepayment and default and the corresponding losses associated with defaults.

When mortgage borrowers default, they generally impose losses on lenders, mortgage insurers, mortgage-based security holders and others. The losses differ by entity and each prices its services accordingly. In addition to setting prices these entities also use non-price credit rationing techniques (credit scores, loan-to-value ratios, income verification, etc.) to limit their exposure to risks. As a result, each institution bears an accompanying distribution of potential losses that varies by borrower and lender and is priced accordingly.

Due to larger variations in lending standards ("flexible lending") and the more precarious financial condition of subprime borrowers it is more likely that subprime lending has both higher loss rates and more variability in loss rates. If priced appropriately, however, no shortage in the supply of subprime loans should result.

Probability distributions of loss rates are not directly observed, but they may be estimated. Using a sample of Fannie Mae and Freddie Mac 30-year, fixed-rate prime and subprime loans, this study estimates probability density functions of loss rates for these two types of mortgages.

The results show that the mean of the subprime loss distribution is 5.15 times higher than the mean of the prime loss distribution when private mortgage insurance is used and 6.0 times higher when PMI is not used. In addition, PMI reduces expected default losses by more than 85% for both prime and subprime mortgages.

One additional feature available from the distributions of losses is that these distributions permit the determination of the economic capital requirements associated with various risk tolerances. Economic capital is defined ...