• Subprime Mortgage Crisis Explained

    By Brandon Cornett | © 2013 All rights reserved

    What is this so-called subprime mortgage crisis I keep hearing about on TV? How did it start, and how does it affect me?

    These are common questions among home buyers, and with good reason. This crisis of subprime lending has had far-reaching effects. It has also made it harder for poorly qualified home buyers to obtain mortgage loans.

    So let's take a closer look at the history, development and impact of the subprime mortgage crisis in the United States.

    Brief History of Subprime Lending

    Through the mid 90's and early 2000's, the number of subprime mortgage loans rose significantly. This was partly due to the increased competition among lender (largely from online mortgage lenders), which meant that lending institutions had to offer a wider range of mortgage products to a larger audience -- if they wanted to stay competitive, that is.

    Many of these lenders began to focus almost exclusively on this type of lending practice, thus they became known as subprime lenders. They saw this as a chance to outmaneuver competitors by extending loans to borrowers that their competitors were turning away. In other words, they offered subprime mortgage loans to subprime borrowers, usually with a much higher interest rate for the borrower ... and higher profit for the lender.

    As with most things in the financial world, this lending practice had an up side and a down side. The down side eventually grew into a full-blown mortgage crisis, but we will get to that soon enough.

    At an annual housing policy meeting in 2004, Governor Edward Gramlich (who was a member of the Board of Governors of the Federal Reserve at that time) had the following remarks about the two sides to subprime mortgage lending.

    On the down side of subprime lending:

    While the basic developments in the subprime mortgage market seem positive, the relatively high delinquency rates in the subprime market do raise issues. ... For mortgage lenders the real challenge is to figure out how far to go. ... If lenders do make new loans, can conditions be designed to prevent new delinquencies and foreclosures?"

    On the up side of subprime lending:

    The obvious advantage of the expansion of subprime mortgage credit is the rise in credit opportunities and homeownership. Because of innovations in the prime and subprime mortgage market, nearly 9 million new homeowners are now able to live in their own homes, improve their neighborhoods, and use their homes to build wealth."

    As stated, there is both a good side and a bad side to the practice of subprime mortgage lending. Yes, these types loans extended home ownership to a lot of Americans who probably could not have afforded a home otherwise. But at the same time, they were a contributing factor in the number of home foreclosures in the U.S.

    At some point, you have to ask yourself: "Should people who cannot afford a home be treated differently from a lending standpoint? Or should the lenders (and the borrowers) just accept the fact that some people cannot afford to buy homes?" There is no easy answer to this question.

    The Subprime Crisis Emerges

    Between 2000 and 2006, the number of home foreclosures continued to rise in America. A barrage of studies and data analysis suggested a strong connection between the rise in foreclosures and the subprime mortgage lending market. As you might have guessed, the federal government raised an eyebrow and began to scrutinize the practices of subprime mortgage lenders.

    The government certainly did not use the "crisis" word, since it's a surefire trigger for panic. But from 2000 onward, many economists were already talking about the subprime mortgage crisis that was headed our way.

    As federal regulators have stepped up pressure and scrutiny, the banking regulators had to tighten their lending standards. We are hearing a lot about this right now, at the time of this blog post (December 2007).

    The Adjustable Rate Mortgage

    The adjustable-rate mortgage (ARM) loan has played a big part in the subprime mortgage crisis. To understand how, we need to briefly discuss the nature of the ARM loan. With an adjustable rate mortgage, the interest rate will eventually reset or adjust at some future point in time. This type of loan starts with a relatively lower interest rate that appeals to borrowers. But it will later reset to a likely higher interest rate -- sometimes a significantly higher interest rate.

    Randall Kroszner, the current Federal Reserve Board Governor, had this to say on the connection between subprime lending, foreclosures, and ARM loans:

    This guidance ... underscores that the Federal Reserve and other banking regulators expect lenders to make sure subprime borrowers not only can afford their monthly payments while the introductory rate is in effect but also after the interest rate resets."

    Impact of the Mortgage Crisis

    When you drop a pebble into still water, it creates a ripple that will continue traveling until it meets resistance or reverse motion. This is an apt analogy regarding the impact of the subprime mortgage crisis in the U.S. The spike in home foreclosures, and the tougher lending standards that were born from it, have had an impact on nearly all aspects of our economy.

    Being Smart About Subprime Loans

    If you ever find yourself in a subprime borrowing situation, the best way to protect yourself is to understand how these things are related (adjustable mortgages, subprime lending, foreclosures, etc.). It's also wise to seek input from an unbiased financial adviser on such matters.

    Of course, by the time I finish writing this history of subprime mortgage crisis, this type of lending might be legislated into extinction, thus making all of this a moot point. But until that time, I hope I've done my part to shed some light for consumers.

    Who Is to Blame?

    Whenever a financial crisis emerges in this country, the blame game starts immediately. So whose fault is all this? Who is to blame for the mortgage crisis that has essentially wrecked our economy? Well, we are all to blame, in one way or another. The greedy lenders are the easiest targets. The politicians who ignored warnings are second in line. And let's not forget all of those consumers who didn't read the fine print.

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