We define "prime" mortgages as those extended to borrowers with a credit score greater than or equal to 660 and a LTV ratio of 80 percent or less. "Nearprime" mortgages are defined as those extended to borrowers with a credit score greater than or equal to 580 but less than 660 and a LTV ratio less than or equal to 90 percent, or to borrowers with an LTV ratio greater than 80 percent and less than or equal to 90 percent and a credit score above 660. "Subprime" mortgages are defined as those extended to borrowers with a credit score less than or equal to 580 or an LTV ratio greater than 90 percent.
Figure 2.1 provides data on the US firstlien conventional mortgage market. In the top row is total mortgages outstanding. In the second row, these mortgages are broken out into prime and nonprime mortgages. In the third row on the left, prime mortgages are broken out into prime conforming and prime jumbo mortgages. In the third row on the right, nonprime mortgages are broken out into nearprime and subprime mortgages. In the fourth row, prime, prime jumbo, nearprime and subprime mortgages are broken out into nonsecuritized and securitized mortgages. In the fifth row, the number of nonsecuritized and securitized mortgages that are fixed rate are provided. And in the sixth row, the number of nonsecuritized and securitized mortgages that are adjustable rate are provided.
Figure 3.1 graphically portrays the economic capital concepts described in the text. In the top panel, the vertical axis, which measures capital in percent of mortgagebacked assets, ranges from 0 to 10 percent. And the horizontal axis, which measures the credit quality index, ranges from 0.10 (for highrisk mortgages) to 1.0 (for lowrisk mortgages). FRB economic capital estimates that are based on stressbased losses range from about 5.5 percent to about 20 basis points and these estimates with respect to the credit quality index trace out a pattern that is convex to the origin. Also in the top panel of figure 3.1 are estimates of Basel II capital requirements that assume a 0.15 asset correlation and that are based on (1) FRB economic capital estimates and (2) stressbased expected losses. The estimate of Basel II capital requirements for mortgages of different credit qualities are always equal to or above the corresponding FRB economic capital estimate for the same credit quality. The outer boundary of the Basel II regulatory capital estimates is convex to the origin and is a fairly close approximation to the FRB credit risk model economic capital estimates.
In the bottom panel of figure 3.1, the vertical axis, which measures capital in percent of mortgagebacked assets, ranges from 0 to 10 percent. And the horizontal axis, which measures the credit quality index, ranges from 0.10 (for highrisk mortgages) to 1.0 (for lowrisk mortgages). The convex outer boundary of the Basel II regulatory capital estimates is presented and ranges from about 5.8 to about 20 basis points. This boundary is always below our prudent economic capital estimates that are consistent with BBB+ to A ratings with the distance between the convex outer boundary of Basel II regulatory capital estimates and the prudent economic capital estimates becoming smaller as one moves from highrisk mortgages (with credit quality index values close to zero in value) to lowrisk mortgages (with credit quality index values close to one in value). The prudent economic estimates range from about 9.25 percent for mortgages with a credit quality index equal to 0.10 to about 22 basis points for mortgages with a credit quality index equal to 0.94. In contrast, Basel I capital requirements for firstlien whole loans are equal to 4 percent regardless of the value of the credit quality index. With regard to mortgagebacked securities, three regulatory capital requirements are presented: (1) the Basel I capital requirements for AAArated securities are equal to 1.6 percent, regardless of the value of the credit quality index; (2) the Basel II capital requirements for AAArated securities are equal to 0.56 percent, regardless of the value of the credit quality index; and, (3) GSE minimum capital requirement for credit risk equals 0.45 percent, regardless of the value of the credit quality index.
Rating Category  Rating Designation Examples 
Risk Weight (in percent) 

Highest or secondhighest investment grade  AAA, AA  20 
Third highest investment grade  A  50 
Lowest investment grade  BBB  100 
One category below investment grade  BB  200 
Longterm Credit Rating and/or Inferred Rating Derived from a Longterm Assessment (1) 
Riskweight for Senior Positions (in percent) (2) 
Base Risk Weights (in percent) (3) 

AAA  7  12 
AA  8  15 
A+  10  18 
A  12  20 
A  20  35 
BBB+  35  
BBB  60  
BBB  100  100 
BB+  250  250 
BB  425  425 
BB  650  650 
Below BB and unrated  Deduction  Deduction 
Source: Basel Committee on Banking Supervision (2004, pp. 128129). Deductions of investments will be 50 percent from tier 1 and 50 percent from tier 2 capital.
Figure has top and bottom panels that correspond to the Basel I regime and Basel II regime, respectively. In each panel, the vertical axis measures the mortgage rate and the horizontal axis measures the probability of not defaulting on the loan, which ranges from 0 (high risk) to one (low risk). Mortgage funding cost curves for a given mortgage market segment are presented.
For the Basel I regime (top panel), the marginal cost function assuming a fixed percent of capital per dollar of mortgage assets (e.g., 4 percent) for depositories is represented by a convex to the origin line and the marginal capital cost associated with prudent economic capital is represented by a steeper convex to the origin line. These marginal costs intersect with each other for moderately highrisk loans with a fairly low probability of not defaulting. Because mortgage securitizers may also have capital requirements that are a fixed percent of capital, the mortgage securitization cost function is parallel to, but closer to, the horizontal axis than is the marginal cost function for depositories. A vertical line, determined by securitizer underwriting standards indicates the lowest borrower quality level that the securitizer is willing to accept. Mortgages with probabilities of not defaulting less than this level are either not extended or are held by depository institutions. Another vertical line, determined by limits to mixing highrisk and lowrisk mortgages to attain an average regulatory capital level consistent with the regulatory (fixed 4 percent) minimum is to the right of the first vertical line. Mortgages with lowerrisk (that is, with higher probabilities of not defaulting) are held by depository institutions. And, mortgages with probabilities of defaulting between the two vertical lines are securitized. The leftmost crosshatched area is bounded above by the marginal cost function assuming a fixed percent of capital per dollar of mortgage assets, bounded below by the marginal capital cost associated with prudent economic capital, and bounded to the right by the vertical line determined by securitizer underwriting standards. The rightmost crosshatched area is bounded above by the mortgage securitization marginal cost function, bounded below by the marginal cost associated with prudent economic capital, and bounded to the right by the vertical line determined by limits to mixing highrisk and lowrisk mortgages to attain an average regulatory capital level consistent with the minimum.
For the Basel II regime (bottom panel), the adopters cost function is identical to the marginal capital cost associated with prudent economic capital. The nonadopters cost function is equal to the adopters cost function for mortgages to the left of the leftmost crosshatched area (identical to the leftmost crosshatched area in the top panel); it is equal to the marginal cost function assuming a fixed percent of capital for the leftmost crosshatched area; it is equal to the adopter cost function between the crosshatched areas; it is equal to the mortgage securitization marginal cost function for the rightmost crosshatched area (identical to the rightmost crosshatched area in the top panel); and it is equal to the adopters cost function to the right of the rightmost crosshatched area. The most risky mortgages (those with probabilities of not defaulting that are very low and to the left of the leftmost crosshatched area) are either not extended or held by depository institutions. And the least risky mortgages (those with probabilities of not defaulting that are very high and to the right of the rightmost crosshatched area) are held by depository institutions. Mortgages with probabilities of not defaulting that correspond to the two crosshatched areas are held by adopters. And mortgages with probabilities of not defaulting that lie between the two crosshatched areas are securitized.
Figure 4.2 presents possible equilibria in a given segment of the mortgage market for the Basel II regime. The vertical axis measures the mortgage rate and the horizontal axis measures the probability of not defaulting on the loan, which ranges from 0 (high risk) to one (low risk). The adopter and nonadopter cost functions for mortgages in this figure are identical to those that were presented in the bottom panel of figure 4.1. Demand curve D1 intersects these curves to the left of the leftmost crosshatched area and demonstrates that interest rates would not change with the implementation of Basel II since both adopters and nonadopters cost functions are equal to each other for these very highrisk mortgages. Alternatively, demand curve D2 intersects these curves inside the leftmost crosshatched region. In this region, Basel II implementation could potentially lower mortgage rates, since deadweight losses (represented by the crosshatched area) would potentially be reduced. Alternatively, demand curve D3 intersects the adopter and nonadopter curves where they are equal to each other because the mortgages are securitized and because marketdetermined capital would back mortgages of such quality. In this case, mortgage rates would be unaffected by Basel II implementation. Alternatively, demand curve D4 intersects the adopter and nonadopter curves in the rightmost crosshatched region, where the mortgage securitization marginal cost function is relevant for nonadopters, but the marginal cost associated with prudent economic capital is relevant for adopters. In this case, mortgage rates could fall with the implementation of Basel II capital standards, since deadweight losses (represented by the crosshatched area) would be reduced.
Note: Standard errors and tstatistics (in parentheses) were corrected for multiple imputation using tools available on the Survey of Consumer Finances website. See Kennickell, McManus, and Woodburn (1997) for a discussion of the techniques that were used. Parameters that are significant at the 10 percent level have one asterisk next to them, and those that are significant at the 5 percent level have two asterisks next to them.
EXPLANATORY VARIABLES  DEPENDENT VARIABLE: Spread of the Mortgage Rate over a Constructed Freddie Mac Benchmark Rate  

Model 1  Model 2  Model 3  
The Effect for Prime Loans (1) 
Additional Effect for NearPrime Loans (2) 
Additional Effect for Subprime Loans (3) 
The Effect for Prime Loans (4) 
Additional Effect for NearPrime Loans (5) 
Additional Effect for Subprime Loans (6) 
The Effect for Prime Loans (7) 
Additional Effect for NearPrime Loans (8) 
Additional Effect for Subprime Loans (9) 

INTERCEPT  0.084 (0.76) 
0.007 (0.03) 
0.539 ** (3.30) 
0.632 (0.24) 
0.621 (0.24) 
3.484 ** (2.45) 
1.593 (0.65) 
1.549 (0.56) 
4.792 ** (2.33) 
CREDIT QUALITY MEASURES  
Credit Score  0.001 (0.36) 
0.001 (0.20) 
0.003 (0.76) 
0.002 (0.78) 
0.001 (0.13) 
0.001 (0.36) 

LoantoValue Ratio  0.009 (1.42) 
0.014 (0.40) 
0.010 (1.08) 
0.006 (0.94) 
0.006 (0.19) 
0.011 (1.23) 

LOCATION  
East 
0.172 (1.09) 
0.069 (.025) 
0.259 (0.57) 
0.457 (1.09) 

Mountain  0.926 ** (3.14) 
0.537 (1.19) 
0.852 (0.82) 
0.141 (0.22) 

Pacific  0.217 (0.91) 
0.257 (0.64) 
0.302 (0.35) 
0.035 (0.06) 

Rural  0.766 ** (2.60) 
0.198 (0.46) 
2.106 ** (1.96) 
1.405 ** (2.34) 

Herfindahl Index  0.648 (0.63) 
2.477 (1.23) 
2.757 (0.90) 
1.766 (0.73) 

YEAR INDICATOR VARIABLES  
1999  0.696 ** (3.20) 
0.366 (1.24) 
0.073 (0.14) 
0.501 (.92) 

2000  0.737 ** (3.39) 
0.651 * (1.78) 
0.375 (0.55) 
0.252 (0.37) 

2001  0.140 (0.50) 
0.454 (1.22) 
0.705 (0.82) 
0.942 (1.51) 

LENDER TYPE  
Depository  0.114 (0.23) 
0.284 (0.35) 
0.447 (0.43) 

Mortgage Company  0.169 (0.31) 
0.406 (0.48) 
0.940 (0.92) 

Credit Union  0.207 (0.278) 
  1.231 (1.00) 

Family or Friend  4.36 ** (4.41) 
3.353 (1.06) 
2.560 * (1.79) 

RSquare (Adjusted RSquare)  0.0483 (0.0429)  0.2386 (0.1904)  0.4432 (0.3245) 
Rankings by Asset Size Are Computed as of 2003
* Bank holding company information derived as the sum of subsidiary bank data. Core deposits consist of transactions deposits, savings accounts, and small time deposits. Managed liabilities mainly consist of deposits booked in foreign offices, large time deposits (with values equal or greater than $100,000) and subordinated notes and debentures.
BANK HOLDING COMPANY SIZE Balance Sheet Items 
1999  2001  2003  

Billions of Dollars  Percent of Total Assets  Billions of Dollars  Percent of Total Assets  Billions of Dollars  Percent of Total Assets  
10 LARGEST  
Total Liabilities  
Core Deposits *  899  30  1199  30  1387  30 
Managed Liabilities *  1401  47  1816  45  2138  46 
Other  447  15  693  17  773  16 
Total Equity Capital  212  7  289  7  328  7 
Total Assets  3011  100  4048  100  4695  100 
NEXT 10 LARGEST  
Total Liabilities  
Core Deposits *  244  36  300  37  345  36 
Managed Liabilities *  267  39  287  35  337  35 
Other  37  5  58  7  68  7 
Total Equity Capital  50  7  65  8  82  9 
Total Assets  675  100  817  100  957  100 
NEXT 30 LARGEST  
Total Liabilities  
Core Deposits *  297  42  360  42  418  41 
Managed Liabilities *  239  34  269  31  314  31 
Other  22  3  61  7  68  7 
Total Equity Capital  56  8  80  9  97  10 
Total Assets  706  100  864  100  1015  100 
ALL OTHER REPORTING BANK HOLDING COMPANIES  
Total Liabilities  
Core Deposits *  840  51  818  49  989  47 
Managed Liabilities *  510  31  382  23  542  26 
Other  126  8  277  17  355  17 
Total Equity Capital  128  8  143  9  185  9 
Total Assets  1639  100  1656  100  2115  100 
Source: Bank Holding Company Consolidated Reports and bank Call Reports as of December 31.
Figure 5.1 presents median estimated prudent economic capital (in basis points) for mortgages in our three broad credit risk market segments.
For mortgages in the prime mortgage market segment for which prudent economic capital falls below 45 basis points, the median prudent economic capital estimate is 20 basis points. For mortgages in the prime market segment for which prudent economic capital lies between 45 and 400 basis points, the median prudent economic capital estimate is 65 basis points. There were no mortgages in the prime mortgage market segment for which prudent economic capital estimate was in excess of 400 basis points.
For mortgages in the nearprime mortgage market segment for which prudent economic capital falls below 45 basis points, the median prudent economic capital estimate is 30 basis points. For mortgages in the nearprime mortgage market segment for which prudent economic capital lies between 45 basis points and 400 basis points, the median prudent economic capital estimate is 150 basis points. For mortgages in the nearprime mortgage market segment for which prudent economic capital is in excess of 400 basis points, the median prudent economic capital estimate is 475 basis points.
There were no mortgages in the subprime mortgage market segment for which prudent economic capital was less than 45 basis points. For mortgages in the subprime mortgage market segment with LTVs less than or equal to 90 percent and for which prudent economic capital lies between 45 basis points and 400 basis points, the median prudent economic capital estimate is 190 basis points. For mortgages in the subprime mortgage market segment with LTVs greater than 90 percent and for which prudent economic capital lies between 45 basis points and 400 basis points, the median prudent economic capital estimate is 295 basis points. And for mortgages in the subprime mortgage market segment for which prudent economic capital was greater than 400 basis points, the median prudent economic capital estimate in 725 basis points.
Figure 5.2 presents the percent of loans in each mortgage market segment where (1) prudent economic capital falls below 45 basis points; (2) prudent economic capital lies between 45 and 400 basis points, and (3) prudent economic capital is in excess of 400 basis points. In the prime market segment, 88 percent of loans have prudent economic capital estimates less than 45 basis points and 12 percent of loans have prudent economic capital estimates that lie between 45 and 400 basis points. In the nearprime mortgage market segment, 7 percent of loans have prudent economic capital estimates less than 45 basis points, 84 percent of loans have prudent economic capital estimates that lie between 45 and 400 basis points, and 9 percent of loans have prudent economic capital estimates in excess of 400 basis points. In the subprime mortgage market segment, about 43 percent of loans have prudent economic capital estimates that lie between 45 and 400 basis points, and 57 percent of loans have prudent economic capital estimates in excess of 400 basis points.
Figure 5.3 provides data on the US firstlien conventional mortgage market. In the top row is total mortgages outstanding. In the second row, these mortgages are broken out into prime and nonprime mortgages. In the third row on the left, prime mortgages are broken out into prime conforming and prime jumbo mortgages. In the third row on the right, nonprime mortgages are broken out into nearprime and subprime mortgages. In the fourth row, prime, prime jumbo, nearprime and subprime mortgages are broken out into nonsecuritized and securitized mortgages. In the fifth row, the number of nonsecuritized and securitized that are fixed rate are provided. In addition, for fixed nonsecuritized mortgage estimates we provide the maximum number of loans contested by adopters and nonadopters over a longperiod, and for fixed securitized mortgages we provide estimates for the maximum number of mortgages contested by adopters and securitizers over a long period. Finally, in the sixth row, the number of nonsecuritized and securitized mortgages that are adjustable rate are provided.