Subprime Meltdown

Subprime mortgages are home loans made to borrowers with poor credit ratings. With rising real estate prices, lenders were encouraged to take in more risks (Liedtke, 2007). Michael Liedtke writes that “subprime lenders made too many loans to borrowers who didn’t make enough money to make the monthly payments. In some cases, lenders didn’t even bother to verify borrowers’ incomes. ” Liedtke adds that because most subprime mortgages carried artificially low interest rates during the first few years of the loan, it took a while for the problems to surface.

When home prices stopped rising after 2005, refinancing became a problem for subprime borrowers because of their lower equity. Senator Christopher J. Dodd gave a summary of the turmoil’s chronology in his opening statements in the house hearing on the matter. Sen. Dodd says that regulators in the U. S. first noticed that credit standards were deteriorating late in 2003. He cited data collected by the Federal Reserve Board that indicated that lenders had started to ease their lending standards by early 2004.

According to Sen. Dodd, in February of 2004 the leadership of the Federal Reserve Board, however, seemed to encourage the development and use of adjustable rate mortgages that consequently defaulted and went into foreclosure at record rates. Press reports started appearing in May 2005, warning about the risks of these new mortgages. By June 2005, Alan Greenspan was talking about “froth” in the mortgage market and testified before the Joint Economic Committee that he was troubled by the surge in exotic mortgages.

Data indicated that nearly 25% of all mortgage loans made that year were interest-only. Yet, in December 2005, the regulators proposed guidance to reign in some of the irresponsible lending. And they had to wait another seven months, until September 2006, before that guidance was finalized. (Dodd, 2007) Sen. Dodd laments that it was only in March 2007, “more than 3 years after recognizing the problem,” that the regulators agreed to extend these protections to more vulnerable subprime borrowers.

Michael Lim at the Philippine Daily Inquirer writes that the subprime mortgage crisis blow-out began in June this year with the collapse of two hedge funds managed by Bear Stearns, which quickly affected other sectors of the financial markets not only in the United States but also throughout the world. Lim adds that it “reached crisis proportion in August-September when it temporarily froze up the money market sector, which is the lifeblood of the banking and financial industry. ” Causes Sen. Dodd has outlined the role of mortgage lenders and regulators in the subprime meltdown. Sen.

Dodd implied that even when it was aware of the potential problem, regulators “encouraged” the “development and use of adjustable rate mortgages” that resulted to defaults and foreclosures. Fitch Ratings Ltd. reports that the early deterioration in 2006 vintage performance is attributable to a confluence of the following factors: The precipitous decline in home prices that began in mid-2006. Fitch has found that even subprime loans of average risk are defaulting at elevated levels. The prevalence of simultaneous second-lien (SSL) lending and loan programs with limited or no income verification (stated income loans).

Weak underwriting and overemphasis by lenders on higher Fair Isaac & Co. (FICO) scores to counter the added risk associated with the stated income and SSL attributes. Growing evidence of aggressive or fraudulent use of stated income, misrepresentation of occupancy status by speculators, and “credit doctoring. ” Les Christie, writing for CNN Money, details the blame game: Mortgage brokers: Brokers steered borrowers to loans they couldn’t afford. Christie explains that the huge increase in mortgage originations, including a spike in refinancings, during the first half of the 2000s, attracted a flood of new mortgage brokers into the industry.

Despite a lack of experience, many were soon earning six-figure incomes. They soon found themselves unable to churn out new deals as business slowed in late 2005, so much so that they provided loans for people with poor risks. (Christie, undated) Michael Lim of the Philippine Daily Inquirer adds that brokers enticed these borrowers into availing themselves of housing loans with minimal down payment and lax documentation and credit checks. Lenders: Lenders made far too many loans to borrowers they knew, or should have known, would not be able to pay them back.

That, probably more than any other factor, will drive an increase in foreclosures during the next year or two. (Christie, undated) Wall Street: While banks and other financial institutions repackaged the debts with other less risky debts and sold them to investors worldwide as collateralized debt obligations, investors bought securitized loans with no regard for whether they met underwriting standards. (Christie, undated) Realtors: Real estate salespeople are not always scrupulous about fulfilling their fiduciary responsibilities to their clients.

They sometimes persuade consumers to overspend and take on mortgage payments that may ultimately be unaffordable. But borrowers, too, have to take responsibility for staying on budget. (Christie, undated) Appraisers: Inaccurate and inflated appraisals have pushed up the amount of money a borrower could loan. It also fed “rising home prices, which, by making homes less affordable, ensured that more borrowers would default. (Christie, undated) Borrowers: There’s certainly lots of responsibility here, especially for the borrowers who were less than honest about their finances.

Others can be blamed for not being more pro-active or diligent about obtaining the right kind of loan for themselves. It’s also true, however, that consumers tend to be very naive about home buying; very few of us do it more than every 10 years or so. It’s a complicated transaction that many are not really up to and they rely on industry professionals to guide them though it. (Christie, undated) Consequences John W. Schoen, in his analysis for MSNBC, says that the immediate pain is being felt by the holders of the 20% of the loans written in 2006, worth about $600 billion that went to subprime borrowers.

With higher interest rates, lenders tried to make it easier on subprime borrowers by lowering monthly payments with a variety of “exotic” mortgages, where in only interest is charged, or there’s a lower starter rate for the first few years. The hope was that as housing prices rose, borrowers could refinance and head off increases in monthly payments. (Schoen, 2007). Schoen explains that with some $235 billion expected to be reset to higher rates, and if lenders now decide that these borrowers are too risky, more defaults could be coming. Other individuals, are likely to feel the pain. Schoen adds:

Homeowners who are looking to sell their homes will be selling at a lower price. Liedtke explains that with more subprime borrowers defaulting on their loans, it will mean even more “for sale” signs on in an already sluggish market for home sales. Investors who bought the subprime loans would have to bear the risks. Investors in lending companies are seeing stock prices fall. Job growth is stalled. Schoen writes that since April 2006 to February 2007, 176,000 jobs were cut in the housing-related industries. Schoen also says that more jobs will be cut in the financial services industry as more and more lenders have gone out of business.