The Sub-prime Mortgage Meltdown

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Someone had to know that this was going to happen.  Certainly, someone could look at the inherent risk associated with borrowers with huge red flags, huge layers of risk and know that eventually it would catch up with the industry and create a serious problem.  Apparently, no one (or at least not enough people) thought it all the way through . . . and the lenders that were making lots and lots of loans (and great money — who can’t make great money when you are charging rates at 8.5% or 9.5% on 2 year adjustable rate mortgages with big $$ pre-payment penalties) are the same sub-prime lenders who are now closing their doors and going out of business. 

So what is a sub-prime loan?  and why all the trouble?

 Sub-prime mortgages have been around for years.  Any loan that doesn’t fit into the category of an “A” borrower (recent credit problems, bankruptcy, collection accounts, past foreclosures, etc) can get an alternative loan using a sub-prime mortgage product.  Most of these products are meant to be short-term solutions or what is sometimes referred to as band-aid loans.  A borrower with past credit problems can purchase a house (with a higher interest rate and possibly a higher downpayment requirement), keep the loan for two to three years and then refinance out of that loan into a loan with more favorable terms.  Most sub-prime loans are short-term adjustable rate mortgages (fixed for only two or three years), which then adjust after the fixed term.  If advised correctly, these loans are perfect for borrowers who have had credit issues in the past and are in the process of re-building their credit and getting their finances back in order.  They can purchase a house now (taking advantage of the tax deduction of owning a house as well as the other benefits of owning versus renting) . . . and after two years, their negative credit is that much further behind them, and with a 24 month perfect mortgage payment history and other re-established credit, they can refinance out of their higher interest rate loan into a conforming “A” borrower loan immediately after the pre-payment penalty expires.

In the past few years, investors had become more and more aggressive as to their credit and financing guidelines . . . allowing borrowers to purchase homes with $0 down at credit scores in the high 500’s; some lenders approving loans to borrower’s with no established credit history, excessive debt to income ratios (borrowers with debt obligations taking up 50 to 55% of their gross monthly income), up to $5,000 in outstanding collections, rent history late payments, and pretty much any other credit malady that you can imagine.

So, with the excitement of the possibility of homeownership (and possibly even a pushy-loan originator), some borrowers found themselves in homes (which are 100% financed) at payments they can’t really afford (probably more than what they had been paying in rent), with a track record in the past of damaged credit, collections and late payments.  And in the scenario above (the plan of getting into the house for a couple of years and then refinancing out of the mortgage), it only really works if the client’s credit is PERFECT for those 24 or 36 months.  One late payment (even on a small account) could be enough to where refinancing at the end of the fixed-term is difficult . . . maybe even impossible.  And then the interest rate adjusts and the problems get even worse.

All adjustable rate mortgages are based on two components — the index (a floating variable such as the LIBOR index or the MTA index) and a margin (a fixed number associated with the loan and established at the time of securing the loan).  Most borrowers (99.99%) only focus on the interest rate of their mortgage, never even asking (or knowing to ask) about their margin.  Most “A” type loans are based on the LIBOR index and carry a margin of 2.25% to 2.75%, so an “A” type loan that adjusted today would adjust to 5.203 (12 month LIBOR index) + 2.25% = 7.45%, rounded down to 7.375% and subject to any cap associated with the mortgage.  A sub-prime mortgage may be based on a similar index, but may have a margin of 7 to 8% . . . the equivalent of adjusting up to 12.5% based on today’s index.

So now, at the time of adjustment, for the borrowers who were not able to better their credit situation, they are left with a mortgage payment increasing by hundreds of dollars (hundreds over what they could barely afford to begin with) to a house on which they owe a loan for close to the entire value of the property (100% financing . . . even over the course of two to three years, if the house increases in vale at 4% per year, they may have just enough equity to break-even on the sale of the house once realtor fees, closing fees, inspection repairs, etc. are paid for).  And with a softening housing market (houses not selling as quickly and houses not realizing the same appreciation rates as in the past), many loans are going into default and the properties into foreclosure.  The foreclosures and defaults have caused lenders to tighten their guidelines making it even more difficult for troubled borrowers to refinance and the whole thing snowballs.  Troubled borrowers can’t sell (easily) and can’t refinance . . . so they walk away.  A foreclosure on their already “less than perfect credit” has now wrecked their credit and it will be four to five years (or more) before the possibility of owning a home again is even a possibility.

So will sub-prime mortgages disappear all together?  Probably not.  There are still instances where ‘bad-credit happens to good people’, and a sub-prime loan is the perfect tool to help fix the situation.  There are other instances where, well maybe it’s just better that those loans just aren’t around anymore — kind of like the saber-toothed tiger . . . have you ever heard anyone say, “Man, I really miss that program where I could borrow 100% of the value of my house at 9.25% rate on a 2 year interest-only ARM with a 8% margin and a 5/5 cap and a $2,000 prepayment penalty.”  Yeah, the good-ole saber-toothed . . . I sure do miss that tiger.

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One Response to “The Sub-prime Mortgage Meltdown”

  1. Trickle-down-sub-prime-mortgage-meltdown-omics « The Mortgage Blog Says:

    […] The Mortgage Blog Professional, Honest Mortgage Advice from Jeffrey Pinkerton « The Sub-prime Mortgage Meltdown […]

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