What does Subprime mean? (8/27/2007

Subprime lending has been the buzz word of 2007. Many media outlets have failed to explain exactly what “subprime” means. Most of the articles I’ve read regarding “subprime” lending practices were intended for audiences in the financial industry. I'll try to explain exactly what “subprime” means, why it’s bad, and what it means to all of us.

The term has been applied to a number of different entities. There are subprime loans, subprime lenders, and subprime borrowers. The term “subprime” refers to a common practice of providing loans to borrowers that would otherwise not qualify for a loan under normal circumstances due to bad credit history, unstable employment, or a host of other negative factors.

The practice of subprime lending became popular between 2002 and 2004 when mortgage rates dipped very low and the real estate market saw a dramatic increase. As homes increased in value and mortgage rates dropped, the industry saw a substantial increase in mortgages, both refinances and for new home purchases. As a result, the industry became very competitive, not only for qualified borrowers with good income and good credit history, but also for a new consumer base. This new consumer base included borrowers with one or more of the following risk factors:
1. Had little or no money to put down on their purchase.
2. Had bad credit history.
3. Were self-employed in a fairly new business.
4. Worked on commissions only (unstable income).
5. Had very high debt ratios (income with relation to debt).
6. Had erratic employment history.

Since the economy was stable and home values continued to rise, the perceived risk in providing mortgages to borrowers that had one or more of these risk factors was very low. So, the subprime mortgage was born. Subprime loans are considered high-risk loans due to the borrower’s risk factors. Subprime lenders typically offer unfavorable loan terms, such as higher rates and higher fees, to help justify doing the loan. Subprime lenders felt that as long as the real estate market was on the rise, they would always have sufficient collateral in the event that a subprime borrower had to default on their loan.

The reason you’re hearing so much about subprime loans now is because a number of borrowers who had these loans can’t afford their mortgage anymore. In many cases, those unfavorable terms included an interest rate adjustment, also called an ARM (adjustable rate mortgage). From 2004 to mid-2006, the Federal Reserve Board raised the fed funds rate 17 straight times to help stabilize an economy that was growing at a very high pace. This increase in rates is directly correlated with an increase in those mortgage loan rates at each adjustment period.

Those rate adjustments took a number of borrowers by surprise. If your mortgage loan has a small balance, say under $100,000, then the rate won’t have a huge impact on your monthly payment. However, if your mortgage has a large balance or you were stretched financially when you committed to the loan originally, these rate adjustments were enough kick a number of borrowers out of their American dream.

Here’s an example: If you borrowed $400,000 at 5% in 2002 with a 5-year ARM, your payment would have been $2,147. In 2007, your rate could adjust today to 7% (typically, there’s a 2% maximum on each increase) and your payment would increase to $2,596, an increase of $449. Since they were considered risky loans, many subprime lenders didn’t offer a maximum of 2% each increase and rate adjustments were more frequent. And since many subprime borrowers were stretching their monthly income to begin with, this increase of $449 would be too much for them to handle.

Now the domino effect…Many of these subprime borrowers had to get out of their expensive home and downsize, quickly. Therefore, in a number of areas in the country where the real estate market was considered “hot” a few years ago, there are more sellers than buyers. Simple economics would indicate a drop in prices. Since a number of these subprime borrowers have a mortgage equal to 100% of the cost of their home, and now their home’s value has decreased, they now owe more on their mortgage than they can sell their home for. This is why a number of these loans are going into default.

Now, how does this affect you and me? First of all, subprime mortgages are now considered bad. Therefore, a lot of the mortgage brokers that offered them, are now out of business. If you have bad credit, unstable income, or don’t plan on providing at least 20% towards the purchase of a home, the odds of you getting a mortgage have dramatically decreased. Instead of offering loans with unfavorable terms to high-risk borrowers, they simply aren’t lending to those subprime borrowers anymore.

Secondly, since mortgages are tougher to get and rates are higher, less people are buying now. If less people are buying, the value of your home probably isn’t going up like it did from 2002 to 2004. As a matter of fact, if you live on the West Coast, the East Coast, or Florida, it’s likely that the value of your home has dropped in the past year. These are the areas that experienced the most rapid increase in home values over the last several years. They are also same areas that forced so many average income citizens to obtain huge mortgages for even modest homes. If you live in these areas, you know what I’m talking about.

Thirdly, your investments may have taken a hit as a result of subprime mortgages. Mortgage brokers don’t “hold” mortgages. They sell them. Mortgages are considered investments since they have a principal balance and people pay interest for them. These mortgages were “bundled” and sold as bonds to investors. They were considered safe investments since they are loans collateralized by real estate that was, seemingly, supposed to continually rise in value. Since employment rates were very low and the economy was strong, these investors figured people would continue to make their mortgage payment. What these investors didn’t know is that a number of those bonds included subprime loans that were provided to high-risk borrowers to begin with, and the increase in interest rates was enough to send many borrowers into a default situation. When people stop paying their mortgage, and the collateral (their home) isn’t worth what they owe the bank, the mortgages become worthless paper. Now the bonds that hold those worthless mortgages drop in value. If one bond that holds mortgages drops in value, everyone that holds a bond that includes any type of real estate holding freaks out and tries to sell. Now they all come tumbling down.

Now, it’s not all that bad. This “subprime meltdown” accounts for a very small percentage of the overall U.S. economy. In a way, this meltdown can be looked at as positive (except for those borrowers that had to default on their mortgage and move in with the in-laws). I think this will force lenders to tighten credit policy and stop lending money to those that can’t adequately afford it. It will also help curb “predatory” lending practices. “Predatory” lending is the practice of offering bad loan terms to borrowers that otherwise couldn’t get financing through a legitimate source. This is also a wake-up for consumers to make sure their credit is in good standing and to make good financial decisions. If many of these subprime borrowers had made good financial decisions, they wouldn’t have gotten themselves or the U.S. economy into trouble.

If you have any additional questions on this topic, or have suggestions for future topics, please don’t hesitate to contact me.