How the Subprime Mortgage Crisis Works

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How the subprime mortgage crisis works

The name itself is numbing. It is called the "Subprime Mortgage Crisis". It is hard to think of a less sexy name. Yet this crisis is all over the news right now and it is having a big effect - on the stock market, on home prices, on the ability of people to get mortgages, etc. How big of an effect?

According to the Wall Street Journal:

"The property value of U.S. homes will fall by $1.2 trillion, and `at least' 1.4 million homeowners will lose their properties to foreclosure in 2008, according to a study released Tuesday by the U.S. Conference of Mayors and the Council for the New American City. The study, prepared by forecasting firm Global Insight Inc., predicts a widespread and deep economic impact from ongoing housing market problems, which many expect to stretch through next year."

That is a big effect. Although it is not quite so portentous as it sounds. This has been building for quite some time. There were 1.2 million foreclosures in 2006 and we survived that without any catastrophic problems. So 1.4 million in 2008 is not going to kill us. The difference is that, right now, the crisis is getting a huge amount of press.

Where did this crisis come from? The name, unsexy as it is, says it all. The word subprime refers to a type of borrower. A person who has been categorized as subprime is someone who has an imperfect credit history.

For example, the person may have had a problem with missed payments, or a prior foreclosure or bankruptcy. This leads to a low credit score, generally below 630. In other words, this type of borrower is considered be at a higher risk for defaulting on a loan.

So a subprime mortgage is a mortgage given to a subprime borrower. The general idea in a subprime mortgage is that, because the person is a higher risk, the person will be charged a higher interest rate. There are a number of ways to charge a higher rate. For example, the person might be given an adjustable rate mortgage that has a low rate initially. This is often referred to as a "teaser rate." Then, after two or three years, the rate adjusts much higher.

That doesn't sound so bad. The thing that caused the subprime mortgage crisis is the fact that the people who give out mortgages went nuts. They started giving gigantic mortgages to subprime borrowers who couldn't possibly pay them back. How nuts did they go? A recent Wall Street Journal article describes one case that is not atypical. A single mother making $2,833 a month ($34,000 per year) got a no-money-down mortgage on a $385,000 house in 2005.

Now just think about that. If she had gotten a normal 30-year fixed mortgage at 6 percent on $385,000, her monthly payment would have been $2,308. Obviously a person making $2,833 cannot make payments on a $385,000 mortgage, especially when you add in the additional things like property taxes, homeowner insurance, repairs, etc.

This mortgage was absolutely ridiculous from the start. And since she was subprime, she would not have gotten a 6 percent interest rate. So why did she get the mortgage? Because, with a super-low teaser rate, the payment might have "only" been $1,200 per month for the first three years. And the idea was that she would be able to refinance into another teaser rate loan before the $1,200 per month turned into $3,000 per month.

That is a great idea until either:

1) Housing prices start falling instead of rising, or

2) Interest rates go up, or

3) The excesses in the mortgage industry get to be so great that regulators finally start sniffing around (followed by the press), or, in the worst case,

4) All of the above.

When that happens, you have millions of people who can't refinance their way out of huge mortgage payments, and these people are prone to defaulting on loans anyway, and the whole thing blows up. You get millions of foreclosures. And since housing prices are falling rather than rising, the foreclosed properties bring big losses to the investors holding the mortgages.

That's where we find ourselves today. It would appear that a group of mortgage lenders found a way to bend the rules, and no one was regulating them to prevent it, and they made a huge amount of money in the process by writing all those loans. Unfortunately, the actions of these lenders will lead to millions of foreclosures and will have many other long-term effects on the economy as a whole