Understanding the subprime mortgage crisis?

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I just have a quick question about the subprime mortgage crisis. From what I have gathered, the subprime mortgage crisis occurred because banks where offering these adjustable mortgages in which, the monthly payments started out low and then, after about 5 years, they were upped to make up the difference. After that 5 year time period, people realized that they couldn’t make the monthly mortgages payments and were forced to foreclose. Was this not a problem before because we didn’t have these types of mortgages or because the lending regimen for these loans got loose? I also read that it was because interest rates fell and house values were growing between 2004-2005 so the incentive to buy a home was high but I’m not sure why the interest rates would fall and why housing values would grow during that time?

I appriciate all your responses and I’ll pick the best answer so be specific!

3 Comments
  1. Reply
    SmartA$$
    April 29, 2011 at 11:48 pm

    first you need to realize what “sub-prime” means, it does not just mean that the interest rate is adjustable, what it means is that each month the minimum payment is less than the total interest that accrued that month.

    For example, there might be $ 1000 of interest charges for the month, but the min payment is only $ 800. The additional $ 200 is added to the balance of the loan.

    These loans became popular when housing prices skyrocketed, because the value of the house went up faster than the balance of the loan. So people literally could buy a house, have the balance owed go up, but sell the house for more money a few years later and make money on the whole thing.

    The problem came when housing prices leveled out and in some areas even went down. Now people ended up owing more than the house was worth, because they had banked on the value going up. So banks foreclosed houses, but couldn’t sell them for enough to get their money back. Therefore banks started loosing money, and the investors who had invested in those banks started loosing money also.
    Many banks that gave mostly sub-prime loans went out of business completely.

    Addition:
    The “crisis” isn’t that home prices leveled out, or that some people got foreclosed and screwed up their credit. The “crisis” is that so many investors lost money that was invested into banks that gave out these loans. These losses rippled through the whole economy.

  2. Reply
    KIMBERLY C
    April 30, 2011 at 12:13 am

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  3. Reply
    TruthMastaT
    April 30, 2011 at 12:40 am

    Here are the short answers to your questions:

    1. The products you describe are known as “Adjustable Rate Mortgages” (ARMs) or “Fixed-Adjustables” (fixed rate for a period of time and then the interest rate adjusts). ARM loans have been around for decades, so these are not completely new loan products. The subprime market did introduce some innovations, such as “80/20 loans” where the borrower borrows the money for their “20%” downpayment on the bigger “80%” loan. Sometimes these loan products end up having NO equity for the borrower (and therefore little incentive for borrowers to keep up their payments).

    2. There is no such thing as a “bad” loan product in and of itself. ARM loans have a horrible reputation right now but it’s not the fault of the product itself. The problem is (as you mentioned) loose underwriting guidelines where just about anyone (regardless of crappy credit, etc.) could get a loan for a higher rate of interest.

    3. You’re right again. There were tons of incentives to buy homes (including incentives provided by the government if not downright compulsion by the government for mortgage companies to make foolish loan decisions to poor and minority communities which could not afford to make the payments).

    There was not ONE central reason for the mortgage problem. Rather, it was a confluence of factors. I’ll describe the main ones in my answer below.

    Those who study mortgage trends have said that there has been a pretty consistent pattern of a “bust” in mortgages about every 18 years since World War II. We’ve seen problems like this before and we will survive this “crisis.” If you’re looking for a mortgage right now, rates are still very good. The world is not ending (as the politicians who are itching to “help” would have us believe).

    In my opinion, the best way to prevent this from happening again, is for the Free Market system to be allowed to punish bad decisions and reward good decisions (as it always does). Government regulation is just something politicians and anti-business people like to propose because it makes them feel good. In reality, the mortgage industry is already highly regulated… and yet the “mortgage crisis” occurred. One of the many regulations that the government has is to disclose VERY clearly and plainly the interest rate of the loan and any adjustments to the interest rate… and yet borrowers claimed that they “didn’t understand what they were signing.”

    Now to the larger question of what caused the mortgage problem… In summary, EVERYONE involved played a part in the “crisis” to some extent or another.

    BORROWERS — Rather than living within their means, many borrowers decided that they wanted to have a bigger, more expensive house than they could afford. In order to afford these houses, they often turned to loan products such as “Interest Only” loans. With IO loans, you basically pay the minimum amount possible every month and the principal is never reduced. To complicate matters, some loans featured “zero down” where the borrower had absolutely NO equity in the property. Here is an illustration of a typical problem: A property is worth $ 800,000 at the time of purchase. The borrower takes out an Interest Only loan for $ 800,000 (putting nothing down). Then the property value drops to $ 700,000. Now the borrower has a loan for $ 800,000 for a property that is only worth $ 700,000. The borrower has ZERO equity in the property so guess what… they walk away from the property and the lender ends up taking the loss.

    MORTGAGE COMPANIES (BAD OR POOR UNDERWRITING GUIDELINES) — In an effort to make as many loans as possible (and to sell these loans to foolishly eager investors), many mortgage companies relaxed their guidelines beyond reason. Some loans had a Loan-to-Value (LTV) ratio of 100 (or higher on rare occasion!). If the property was worth $ 100,000, then an LTV meant that $ 100,000 was loaned to the borrower (as stated before, no equity). The lower the LTV, the less risky (and more desirable) the loan is. Another arguably stupid mortgage product was the “80-20” loan. A loan with an LTV of 80 or lower is not considered risky in the mortgage business. Therefore, Mortgage Insurance (MI) is not required for loans with an LTV of 80% or less. (If a borrower has an LTV of 85 and pays it down to 80, then they can drop the MI from the loan.) MI is basically insurance against borrower default. For example, if a borrower defaults on his loan and the lender forecloses and sells the property and loses $ 2000 in the process, then the MI company will cut a check to the lender for $ 2000 to make the lender “whole.” Rather than requiring borrowers to carry MI on their loans (which would have mitigated risk), the mortgage companies allowed the borrowers to take out a second loan on the same property (a “second lien” or Home Equity Line of Credit or HELOC). This HELOC money was then used as the “money down” on the first loan so that MI could be avoided. For example, if the property is worth $ 100,000, the borrower might get a HELOC for $ 20,000 and put that money down on the first loan, thereby lowering the LTV to 80 (thereby exempting them from MI). Another popular loan was an Adjustable Rate Mortgage (ARM) or “Fixed-Adjustable” (where the Interest Rate is fixed for a few years and then starts to adjust (up or down) based on a financial instrument). Borrowers were allegedly given a low “teaser rate” and then (because they bought too much house) couldn’t make the payments with the higher interest rate when the rate adjusted. (It seems hard for me to believe that an interest rate adjustment would be so severe that it would prevent someone from making their payments, but that’s what the borrowers allegedly claim.) Maybe this is too many detailed examples, but suffice it to say that a lot of stupid mortgage products were offered by mortgage companies (and accepted by borrowers).

    INVESTORS — In their quest to make a “fast buck”, investors bought up tons of these mortgages since these riskier “sub-prime” loans brought higher returns (higher interest rates). These investors should have performed a “due diligence” on the loans they bought; but they didn’t. When investors purchase loans, there is usually (if not always) a “buyback” provision. This means that if a loan goes bad and the investor finds that there was some irregularity in the underwriting (the loan decisioning process) that the mortgage company who sold them the loan is required to “buy back” the loan. The problem is that most mortgage companies are “cash poor” (meaning that they borrow the cash that they lend from a “warehouse lender” temporarily until they can sell the loan to an investor and pay back their warehouse lender). So when these loans started going bad (hundreds of millions of dollars worth!), the investors demanded the mortgage companies buy back the loans (according to their agreement). So mortgage companies were now looking at buying millions and millions of dollars worth of loans back when they had little or no money of their own! So what happened? Countless mortgage companies declared bankruptcy. With all of the hullaballoo around bad mortgages, investors decided to stop buying sub-prime mortgages. Since there was nobody buying these mortgages and since mortgage companies don’t have their own cash, mortgage companies found that they could no longer make these sub-prime loans. The sub-prime market dried up almost instantly.

    RATING AGENCIES — The job of rating agencies is to investigate the creditworthiness of investments (many of which included mortgage debt). These agencies did not do their due diligence and ended up giving these investments an artificially high rating. So investors thought the investments were less risky than they were. Investors will always buy investments that have a high return and low risk (but obviously they weren’t low risk).

    THE GOVERNMENT — The government has always put pressure on mortgage companies to make loans to poor and/or minority borrowers. Because these borrowers typically have worse credit and/or less income and/or greater debt, they had to go to the “sub-prime” market to get a mortgage loan. Is it so hard to imagine that a borrower with less income, more debt and bad payment habits will default on a loan (especially when they’ve put little or no money down)? Of course not. But the government continues to “wish away” laws of basic economics and common sense. In order to “do right” by poor people and minorities, the government expected mortgage companies suspend their normal sound underwriting guidelines and business sense. (Obviously, the sub-prime problem goes beyond just poor borrowers, but my point is that the government contributed to the crisis to some extent.) The government is now poised and ready to exacerbate the crisis beyond what it is now by “freezing” interest rate adjustments. Here is an illustration of the problem: Let’s say you have $ 5000 in cash. I’m a bank and I tell you that if you deposit your $ 5000 with me that I will pay you 1% during the first 2 years but then I will pay you 7% after those 2 years. So you deposit your money at the low rate of interest. After two years (when you’re about to get your higher interest rate), the government comes in and says, “Sorry. You’re not getting your 7% as promised. In fact, you can’t take your money out of that bank; you must leave it there and only collect 1% for another 10 years.” What will happen when you have another $ 5000 to deposit? Will you put it in my bank? Absolutely not.

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