The Price of Risk for Borrowing Is Up, But Don't Call It a Market Meltdown

By Jack Guttentag
Saturday, August 11, 2007

I have been getting a lot of mail from mortgage brokers and small lenders complaining that they are no longer able to get funding for loans that previously would not have been questioned. One of them described it as a market meltdown.

I have been developing a database on wholesale mortgage prices that lets me peer into the heart of the problem, if there is one. Wholesale prices are those that lenders quote to mortgage brokers and small lenders called correspondents.

My database covers 11 of the largest wholesale lenders. Because they account for a large share of what is an extremely competitive market, it is safe to assume that their prices are representative of the overall wholesale market. While most price differences are small, in every case I took the lowest of those shown.

Wholesale prices have much less statistical noise than retail prices because they do not include markups, which can vary widely from one transaction to another. Further, the transaction characteristics underlying the wholesale data are well-defined. I know the loan amount, property value, type of property, state, purpose of loan, use of property, borrower's FICO credit score, type of documentation, whether the borrower escrows taxes and insurance, and lock period. None of the available data series on retail prices contain this amount of detail on factors that affect mortgage prices.

The data are available for 14 loan programs, of which six are fixed-rate and eight are adjustable-rate. Data are available for individual states and for a U.S. average. Subprime mortgages are not covered, though Alt-A and other intermediate credit categories are included.

To simplify price comparisons, I adjust all rates to zero points and fees. The interest rate is the only price used.

Because this is a work in progress, I don't yet have the data series that permit day-to-day monitoring of the market. However, I did a test run on May 4 covering California and will use that as a benchmark for assessing the state of the market on Aug. 3.

On cream-puff loans, interest rates rose by about 0.4 percentage points from May 4 to Aug. 3. On some programs, it was a little more, on others a little less.

A cream-puff loan is one with a 20 percent down payment on a $500,000 single-family house bought as a permanent residence by a borrower with a credit score of 720 or more. The borrower fully documents income and assets, and escrows taxes and insurance.

The lenders who are writing to me, however, are not complaining about cream-puff loans; their concern is the riskier niches, and the evidence supports their claim. The price of risk has gone up.

One of the tables I ran on May 4 showed the rate at different FICO scores. On scores ranging down to 680, rates on Aug. 3 were about 0.4 percentage point higher, but at 660, the increase was 0.56 percentage point, and at 620, it was 1.4 percentage points. Below 620, there were no quotes on either date; that's subprime territory.

I also looked at rates on loans of different sizes on May 4. The loans were for $75,000, $417,000, $418,000 and $2 million. The two middle sizes distinguish between loans that can and that cannot be bought by the two government-sponsored entities, Fannie Mae and Freddie Mac, which have a ceiling of $417,000 on mortgages for single-family homes in most areas.

The rate increases, starting with the $75,000 loans, were 0.41 percentage point, 0.45 percentage point, 0.74 percentage point and 0.8 percentage point.

The only other risky niche I priced on May 3 was a cash-out refinance for investment on a four-family property, though it had a 20 percent down payment, a 720 FICO score and full documentation. On Aug. 3, the rate on this loan was 1.24 percentage points higher.

A risky niche I had not priced in May but wanted to check was stated-income loans with zero down. I found it priced close to 8 percent for a borrower with a 700 FICO score and more than 10 percent for a borrower with a FICO of 660, with no quotes for scores lower than 660.

It is clear that the price of risk has risen substantially, and the higher the risk category, the larger the increase in price. Some, at least, of the highest-risk niches are no longer being offered. The lowest-risk niches, what I called cream-puff loans, have not been affected at all and may even have benefited. My data don't cover subprime loans, but the plausible surmise is that these loans have been affected most of all because they are the riskiest of all.

This is not a market meltdown. Far from it. In a meltdown, lenders jettison their capacity to assess risk and flee into assets insured by the government. We haven't seen that since the 1930s, and we won't be seeing it now.

Instead, this market is correcting a previous tendency to underprice risk, a tendency arising from a prolonged period of house-price appreciation.

Steady price appreciation almost eliminates the difference in performance between the least risky and the most risky loans. Lenders with short time horizons or poor memories that were willing to price on the assumption that price appreciation would continue forever forced other lenders to do the same to remain competitive.

The fantasy that home prices only rise has been punctured. It is no longer rational to price loans on the assumption that rising prices will convert most bad loans into good loans. The market is now reacting to that realization.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,

Copyright 2007, Jack Guttentag

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