The Mortgage Crisis

The last few years have been great for homebuyers. Banks seemed to be dying to offer us home loans and the Fed kept interest rates conveniently low. House prices were going up and everyone wanted in on the joys of home ownership. Now, however, the overenthusiastic banks are starting to pay the price.

Subprime Lending
There are two areas of the mortgage market – prime and sub prime. The prime market includes the average and above average citizens and companies who pay their bills on time, make plenty of money and are an overall great banking customer. There is virtually no risk in giving loans to individuals in the prime market. They are an excellent gamble.

The subprime market is a much more exciting gamble as it doesn’t always pay off. Subprime lending is a practice of offering loans and mortgages to candidates who would normally not qualify for the money. Subprime borrowers might have declared bankruptcy in the past, have low credit scores, have foreclosures or a history of untimely payments.

Often these borrowers clean up their act for a time under the guidance of a credit counselor, apply for and receive a subprime mortgage. Of course the corresponding interest rate and fees may be considerably higher than a standard mortgage as the bank must mitigate its risk. The subprime market is huge and there is a great deal of money to be made for banks willing to take the gamble.

The Credit Crunch
And for awhile things were looking good. Banks loaned money to almost anyone who applied and interest rates stayed low enough to keep mortgage payments comfortable. In fact, interest rates stayed low so long, the subprime market was expanding more than the prime.

Bundles of subprime mortgage were trading in the markets. They were like junk bonds, a bit risky but highly profitable. To fill the demand, banks kept borrowing to lend to others, and they kept those subprime mortgages coming.

But interest rates didn’t stay low. After years of rock bottom interest rates, the Federal Reserve raised in the prime rate which in turn affected adjustable rate mortgages. They adjusted upward. This adjustment made some mortgages a bit tight, especially in the subprime market.

Borrowers purchased as much house as they could afford, and that was plenty thanks to the lower adjusted mortgage rates. As the rates rise, the payments rise with them and many borrowers can’t cover the adjustment. So they stop paying. The lucrative gamble that was bringing in money hand over fist isn’t looking attractive anymore, and there isn’t anywhere for the banks to go. They are stuck with their loans.

It’s getting harder for banks to borrow money, and this is trickling down to buyers. It will be harder to refinance a home, and adjustable rates will keep climbing. As more people default, the situation will worsen. All this will tighten the noose gradually until the banks remember exactly why the subprime market was originally termed “subprime.”

Join the discussion