subprime mortgage crisis explained
After the dot-com bubble dissipated, the early 2000s were a boom time for the U.S. housing market, aided by growing demand and seemingly limitless financing. Investors were looking for new, post-tech-bubble investment opportunities they found in the form of loans to high-risk home buyers, known as subprime mortgages.
The housing sector was the cornerstone of a strong economy, accounting for 40% of all job creation during this period. Construction starts more than doubled, from an average of 609,000 units per year in 1995 to 1.2 million units in 2005. Average U.S. home prices doubled between 1998 and 2006, while prices in cities like Las Vegas, Miami, São Paulo, Diego and Washington, D.C., rose more than 80 percent, according to the Federal Reserve. This is an era of low interest rates and credit expansion for homebuyers. The homeownership rate, especially for first-time buyers, soared to 69%.
Who is behind this unprecedented financing? Believe it or not, this has global implications. Banks are approving mortgages and then pooling them into interest-bearing packages called mortgage-backed securities. Riskier, higher-yielding securities are called “private labels,” and are then sold to investment banks and traded globally for profit.
How are subprime loans different from other types of mortgages?
In the early 2000s, subprime loans were a newly introduced mortgage loan category. They allow buyers with poor credit (FICO score of 600 and below) to afford their own home.
These homebuyers pay much higher monthly rates than others with better credit, compensating lenders for the added risk.
The following are several types of subprime mortgages:
Adjustable Rate Mortgage (ARM): Homebuyers make a small down payment, and the initial monthly payments start at a lower “advance” rate, which is actually lower than a fixed rate mortgage. After a period of typically about 2 years, these rates spike. Balloon Repayment Mortgage: Payments start with a low interest rate and then become larger, or “inflated,” at the end of the loan. Fixed Rate Mortgages: These “plain vanilla” loans were common in the 1980s and early 1990s and had interest rates that did not change over the life of the loan. Typically, fixed rate mortgages had a longer term than adjustable rate mortgages, making the latter Seems more attractive. Hybrid mortgages: These loans start with a fixed rate, but later include an adjustment period, usually in tandem with the rate. Interest only: For the first few years of this type of loan, the buyer pays only interest. When it renews They have to pay interest and principal when they are placed in. There are also more types of mortgages during this period, such as “No Income, No Job and No Assets” mortgages, or NINJA for short, with advance rates that start to adjust higher The riskier loan is the aptly titled no-down payment mortgage, which requires no money up front.
From 1995 to 2001, subprime mortgage originations jumped from $65 billion to $173 billion. 80% of subprime loans are variable-rate mortgages, which include the above characteristics.
How Safe Are Subprime Loans?
Subprime mortgages create an illusion of affordability, but they often contain hidden fees. In addition to adjustable rates, subprime borrowers have other additional costs—sometimes even principal increases over time.
In low-income neighborhoods, the incidence of subprime loans is three times higher. Predatory lenders use unfair or discriminatory practices to persuade borrowers to take on mortgages they cannot afford. Often, minorities are targeted: Latinos and African Americans are 2.8 times more likely than whites to get subprime loans, according to the Residential Mortgage Disclosure Act. Ohio’s Assistant Attorney General Jeffrey Loeser described predatory lenders going even door-to-door selling subprime loans to consumers who didn’t understand subprime lending.
Understanding Adjustable Rate Mortgage Terms
It’s easy to see why there’s so much confusion around adjustable-rate subprime mortgages — they’re pretty complicated.
The name of an adjustable rate mortgage provides clues about its terms:
The introductory rate for 5/1 ARM is 5 years; after that, rates may change annually. The introductory rate for 3/1 ARM is 3 years, after which the rate may change annually. The introductory rate for a 7/1 ARM is 7 years, and its rate may change annually thereafter, and so on.
After the notice period ends, ARM undergoes an initial adjustment, typically 2%. This means that after the initial rate, the new rate will be up to 2% higher. Additionally, there may be subsequent adjustment periods, each with its own maximum percentage increase.
scroll to continue
street dictionary term
On top of that, mortgage lenders attach another index rate to the total rate, which includes the usual 1% margin. For example, taking a 5/1 ARM as an example, the lender index is 1% and the margin is 2.75%. After 5 years, the adjusted new gross tax rate has increased by 2% to 4.75%. But let’s say the profit margin is 5%. In this case, the new total ratio would be 7.75% – quite a jump!
real world example
Back in 2002, if you had a 3/1 ARM for $300,000, the initial interest rate would be around 5%, and the monthly repayments would be about $1,610.
Three years later, when ARM is initially adjusted, the new rate will climb to 7%, totaling $1,995 a month. That’s a difference of $385 per month, or an annual increase of $4,600.
And this is only the first adjustment.
Too often, lenders don’t prepare their customers for what will happen after the advance notice period, or in the event of an increase in prevailing interest rates. Subprime homeowners simply couldn’t keep up; many fell into default as a result.
What happens when a subprime mortgage defaults?
When it comes to interest rates, the Federal Reserve noted inflationary pressures and took steps to correct them, raising the federal funds rate from 1.0% to 5.25% 17 times between 2004 and 2006. As interest rates rose, banks had to pay more interest to depositors, so did rates on ARMs and other types of subprime mortgages.
Subprime mortgage holders are in crisis.
Millions of U.S. homeowners across metropolitan areas such as Detroit, Las Vegas, Miami and San Jose are defaulting on their loans. Florida and California have been hit especially hard. By 2007, lenders had begun foreclosure proceedings on 1.3 million homes, with another 2 million added in 2008—and more. As of August 2008, more than 9% of US mortgages were either delinquent or in foreclosure.
What is the global impact of the subprime mortgage crisis?
If you’re wondering why subprime borrowers can’t simply refinance their loans, the problem is that home values have also declined during this period. Mortgage-backed securities contain thousands of subprime mortgages, so when the market crashes, so do their bond financings. The securities’ credit ratings were downgraded, making them less attractive as investments. That, in turn, caused lenders to stop approving risky mortgages, reducing housing demand and causing house prices to fall.
It’s like a string of dominoes.
First, New Century Financial, a large subprime mortgage lender, filed for bankruptcy. Then institutions like Fannie Mae and Freddie Mac, whose mission was to make homeownership affordable, suffered incredible losses due to outstanding loans allocated to mortgage-backed securities. The federal government had to bail them out in 2008.
Even investment banks have become vulnerable because they are no longer able to raise funds from securities markets. Lehman Brothers declared bankruptcy on September 15, 2008. A global financial crisis is brewing.
What are the consequences of the subprime mortgage crisis? Can another crisis be avoided?
The subprime mortgage crisis threw the economy into chaos: unemployment rose and GDP fell. Consumer spending has fallen and liquidity has eroded. The United States entered its longest recession since World War II, known as the Great Recession, which lasted from December 2007 to June 2009.
In 2010, under the Troubled Asset Relief Program (TARP), the U.S. Congress approved $700 billion to add liquidity to the market, and the U.S. Treasury injected billions of dollars to stabilize the troubled banking sector. Through the program, banks are encouraged to reprocess payments on “underwater” mortgages instead of seeking foreclosure. Homebuyers received temporary tax credits, and the Federal Housing Administration increased the amount that can insure mortgages.
Between 2008 and 2014, the Federal Reserve cut interest rates to near 0%. It has also embarked on a series of quantitative easing measures to increase the money supply and encourage lending until employment levels rise again, with additional government support to stabilize sectors such as the U.S. auto industry.
Do subprime mortgages still exist?
Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010 to reform the financial industry and prevent another crisis, a new regulatory agency was created: the Consumer Financial Protection Bureau. The aim is to impose stricter regulation on the banking industry and protect consumers from discrimination, including predatory lending. Part of the Dodd-Frank Act, the Volcker Rule, prohibits banks from trading in speculative assets, such as high-risk, high-yield derivatives.
However, subprime mortgages still exist today – they are now called non-prime loans. Thankfully, their structures are less complex than their historical counterparts. Plus, most now have rules that allow variable rates to be adjusted lower once a homeowner’s credit score improves.
ARM’s share of the housing market has fallen sharply; they currently account for less than 10% of residential mortgages.
Will there be another subprime mortgage crisis in 2022?
Michael Burry, one of the first investors to bet on subprime mortgages in the mid-2000s, recently posted another cryptic tweet.