ROYAL BANK OF MIDWEST
(Middletown, December 2006) Owning a home is part of the American dream. Having a home creates
ties to the community, provides stability, and promotes civic pride. This desire for home ownership is so
much a part of the American culture that governments promote this ownership by providing significant tax
incentives. Mary Lloyd is Senior Vice President for Mortgage Lending at a medium sized bank, Royal
Bank, operating in the Midwest. Mary prides herself in her role of helping her customers realize this
American dream. She wants to help extend the opportunity of home ownership to her customers who
previously would not qualify for a home loan from Royal by convincing the bank management to enter into
the subprime home lending market.
Royal has been a fairly conservative banking institution, concentrating on commercial lending to local
business and low risk home loans. The home loans extended by Royal are to prime borrowers. These
borrowers have reasonably well established credit and borrow in loans conforming to Fannie Mae or
Freddie Mac criteria. Such loans can be packaged and sold through these government-sponsored
agencies. The risk to the bank is low, many of the loans are sold to other institutions and pension funds
while the bank earns fees for processing the payments. Prime borrowers generally had credit scores of
640 or higher.
In managing the loan business for her bank, Mary sees her job as dealing with two significant problems.
Prior to extending a loan she must deal with adverse selection. Once the loan is extended she needs to
provide sufficient incentives to reduce the moral hazard problem. Adverse selection results from
asymmetric information. The potential borrower knows more about their likely behavior and financial
condition than the bank. If the bank establishes a lending criteria that is significantly more lenient than its
competitors, the borrowers selected are more likely to be higher risk and less likely to maintain their
payments. Once the loan is extended the borrowers might expose the bank to unanticipated risk by
failing to maintain the property. Mary sees this moral hazard problem being reduced by requiring a
minimum down payment of10 percent of the property’s value. Since the first party to incur a loss, should
the property value decline, is the homeowner, they have an incentive to maintain the value. The adverse
selection problem is managed by screening the applicants. A potential borrower’s credit score has
proven to be a useful screening device.
Mary has been frustrated by having a screening rule that only permits loans to highly qualified borrowers.
Since her bank only issues prime mortgage loans, she must turn away business from borrowers with 640
or lower credit scores. She has watched her competitors enter the less than prime (subprime) market
with a high degree of success and seen many of the subprime borrowers succeed in making their housing
payments, improve their credit scores, and achieve their dream of home ownership. Mary believed that
these potential borrowers should not be denied the opportunity of home ownership just because of a few
late payments, difficulty in documenting their income and, perhaps, a prior bankruptcy. If they were given
the opportunity and provided financial counseling to help them manage their incomes, they would become
good customers for the bank, provide an additional source of bank income, and become more productive
members of the community.
The subprime market developed in the late 1990s. These loans were designed to provide potential
homeowners with less than perfect credit the opportunity to get back on their feet, improve their credit
rating, and ultimately refinance into a prime loan at lower rates. The initial subprime loans required a 20
percent down payment, had a fixed interest rate for the first two years that was generally 2 percent above
the prime, 30-year fixed rate, and moved into an adjustable rate mortgage (ARM) after two years. Moving
into the 2000s, housing prices were rising, equity was being built up for the homeowners and the loans
were profitable. With the subprime loans improving bank profitability, banks and mortgage lending
institutions moved to make their loans more attractive. The down payment requirements dropped to 10
? Copyright 2009, Dr. Gordon Johnson, Dr. William Roberts, and Dr. Elizabeth Trybus
The authors would like to thank Fred Arnold for helpful information on the subprime mortgage market.
percent. Institutions, in some cases, would issue loans for 100 percent of the property’s value (no down
payment). In order to provide additional loans, second loans were sometimes issued to subprime
borrowers to permit them to take acquired home equity out of the house. While the latest movement
towards more lenient lending criteria has Mary a little worried, she still sees the subprime market as a
vehicle to help both her bank, with higher profits, and her customers, by providing them with the
opportunity of home ownership.
The subprime loans Mary wishes to make would require at least a ten percent down payment, have a
fixed rate for two years, include a prepayment penalty during the first two years, and become an
adjustable rate mortgage (ARM) after two years. To compensate for the added risk associated with these
loans, the fixed rate would be 2 percent higher than the bank’s traditional prime home mortgage loans.
The ten percent down would protect the bank in the case of foreclosure, and the future adjustable rate
would make the loan attractive on the developing secondary market for subprime loans. The ARM is
indexed relative to the 6-mo LIBOR (London Interbank Offer Rate). Mary is comfortable with these
features. She believes that her borrowers would make their mortgage payment, reestablish a higher
credit score and be able to refinance after two years into a lower rate prime loan.
Required
Mary has some concerns over entering this market and has hired your consulting firm to help her resolve
these concerns and recommend how she should proceed in this market. Please write a report using the
form recommended on the Gateway web site. (This case takes place in December 2006. While you
have future events in this industry available, you need to make your case on data available prior to
January 2007.)
In preparing your answer be sure to consider statistics concepts 4, 5, 6, and 8 and macroeconomics key
concepts 4, 6, 7, and 9.
The available data is in the Excel spreadsheet found on the course web site. Note that the data is
contained in two sheets.
Mary wants to sell some of these subprime loans on the developing secondary market. However, she also wants the bank to retain some in their asset portfolio to add income and make the stockholders happy. She wants an evaluation of the associated risks and a recommendation on whether or not to hold or sell. What are the possible gains and losses to the bank after December 2006?
