How the subprime mortgage crisis works
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. [ref ]
That is a big effect. Although it is not quite so portentous as it sounds. This has been building for quite some time, as you can see in this post from a year and a half ago. Also note that there were 1.2 million forclosures in 2006 [ref ] and we survived that without any major 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, some of them rather uncomfortable. For example, the person might be given an adjustable rate mortgage that has a low rate initially and then 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 higher risk borrowers who couldn't possibly pay them back. How nuts did they go? This article gives a little insight into the problem:
From the article:
Ana Cecillia Marin, a 36-year-old single mother of three, owns a 20-year-old ranch house on a dusty, garbage-strewn acre in Palmdale, Calif. She says she earns $34,000 a year managing flower sales at a Los Angeles food store and selling clothes on the side. She bought her house in 2005 for $385,000. By taking out a first and second mortgage, she was able to buy it for no money down.
Do the math and you can see the problem:
1) If Ana Cecillia Marin had gotten a normal 30 year fixed mortgage at
6% on $385,000, her monthly payment would have been $2,308 [ref ].
2) If you make $34,000 per year, you are only making $2,833 per month (ignoring taxes, FICA, etc.)
So obviously this mortgage was absolutely ridiculous from the start. And since she was subprime, she would not have gotten a 6% interest rate. Obviously she is going to default on the loan and go into foreclosure. Multiply that kind of ridiculous mortgage across millions of people and you understand how the subprime mortgage crisis works.
The big question you might have is: why did this happen? What happened to the old guidelines that would have prevented this? For example, if you look at this site. it says:
Lenders use many factors to determine how large a mortgage you can obtain. For example, lenders generally prefer that your housing expenses (including mortgage payments, insurance, taxes, and special assessments) do not exceed 28% of your gross monthly income. Other debt added to your housing expense should not exceed 38% of your gross monthly income. Federal Housing Administration (FHA) and Department of Veteran Affairs (VA) mortgage loan percentages may vary.
What happened to that 28% limit, which would have capped Ana Cecillia Marin at a mortgage payment of $793?
Those limits went out the door. OR, they were bent by "teaser rates". Mortgage lenders would put together a package that included an interest-only loan at a low introductory rate of, say, 4%. After 2 or 3 years that "low introductory rate" would evaporate. But the idea was that, at that point, you would re-finance into another loan, which would restart the "low introductory rate" clock.
That is a great idea until either:
a) housing prices start falling instead of rising, or.
b) interest rates go up, or.
c) the excesses get to be so great that regulators finally start sniffing around (followed by the press), or, in the worst case.
d) all of the above.
Then you have millions of people who can't refinance their way out of huge mortgages, and these people are prone to defaulting on loans anyway, and the whole thing blows up.
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. 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.Source: blogs.howstuffworks.com