Subprime Mortgage Market Collapse: A Primer

Subprime mortgage market. The words these days raise fear in the hearts of mortgage lenders and market prognosticators.

Last week, U.S. financial markets learned that late payments on U.S. mortgages had reached their highest level in over three years. Stocks fell and bond prices rose as the Mortgage Bankers Association reported rising delinquencies in 49 states and among all loan types, particularly in subprime adjustable-rate loans.

This news was merely confirming what many in the industry have known for months – the subprime market is struggling, even teetering on the precipice of a major fall. One of the largest subprime lenders, HSBC Holdings, announced early in February that bad debts in 2006 exceeded $10.5 billion in 2006. Dozens of smaller companies have been falling by the wayside everyday. And the industry is wondering where and when it might stop.  

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Subprime Explained

Subprime mortgages are those made to borrowers with credit scores that traditionally denoted a risk. Credit scores are awarded on a scale of 300-850. Prime borrowers are those with scores around and above 700. Those with scores below 620 have credit issues and are considered a risk by lenders.

On the basis of a strong and growing stronger housing market in the last few years, lenders began taking another look at potential borrowers with low credit scores. These “subprime” borrowers were offered home loans at higher interest rates than those paid by prime borrowers.
 
In 2005 the Federal Reserve began a series of 17 hikes in the short-term interest rate, rising from 1% to 5.25%. Most subprime loans are based on floating interest rates that change as the short-term interest rates change. From this series of hikes, then, many homeowners who received loans before or around this time are now facing 30-50% increases in their monthly payments.

The result is an increasing number of loan defaults and delinquencies.

Subprime Troubles Charted

Depending on the source, subprime loans made up as much as 23% of the housing market in 2006. The increasing number of defaults and delinquencies means more than just homeowners in trouble.

Subprime loans are usually packaged and sold to investors. With sometimes marginally qualified borrowers and increasing interest rates, delinquent payments, defaults and foreclosures began occurring in increasing numbers. While these loans were sold to investors, the sale contracts call for the lenders to buy back defaulted or delinquent loans.
Lenders are struggling with buying back these loans, causing some major financial hits. Within the last year, numerous companies across the country have pulled out of the subprime market, been bought out, sought bankruptcy protection or have otherwise shut down.

Effects on Housing Market

What will the self-combusting subprime market mean for other borrowers and lenders?
Many think tanks and organizations are predicting that the subprime collapse is only starting. The Center for Responsible Lending predicts that almost 20% of subprime mortgages originating in the last two years will end in foreclosure. Many more defaults and delinquencies will occur, as the first rate adjustment on adjustable-rate mortgages come due.
Market experts and prognosticators are torn on the effect of the subprime downfall on the rest of the market. Many already agree that the market is cooling, and perhaps nearing dangerous lows. Some say that the subprime debacle is forcing homes onto the market, depressing prices of all homes, even “prime” borrowers. If this continues, or if interest rates rise again and increase the number of defaults and delinquencies, home values will be flat or falling. Owners will no longer be able to use refinancing to convert equity into cash, cutting consumer spending. The home market slump can persist or increase.
To stem the bleeding, four groups of banking regulators--Office of Comptroller or Currency, Federal Deposit Insurance Corporation, Office of Thrift Supervision and National Credit Union Administration—have proposed a guidance to restrict subprime mortgage loans. The guidance calls for lenders to impose tougher standards, and to research a true and accurate picture of the potential borrower's ability to repay a loan.
Keep track of the subprime market and the housing market by checking ERate regularly for updates.

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