The Mortgage Professor
Unearthing the Roots of the Subprime Problem
Extensive payment problems with subprime mortgages, along with the failure of a number of subprime lenders, have been major news lately.
The subprime mortgage market caters to borrowers with imperfect credit or other weaknesses, such as insufficient cash for a down payment. Speculation about the causes of the defaults has been widespread. This week, I'll be writing about those causes. In the next few weeks, I will look at why so many lenders have failed; the impact of the crisis on the availability of credit to prospective subprime borrowers; what, if anything, the government should do; and whether the subprime market could and should be replaced -- and, if so, by what.
Why have problems arisen in the subprime market?
Home buyers with these loans had negative equity the day they closed, in the sense that if they were forced to resell immediately, the transactions costs, which can be 5 percent or more, would have to be paid out of their pockets. The buyers looked to appreciation to cover the costs and make a profit.
When the appreciation doesn't materialize, even if the payments remain affordable, the financial incentive to make them is substantially weakened. Most owners do continue to pay because they want to remain in the house and they don't want to ruin their credit, but some fold their cards and walk away. The result is a foreclosure.
Some of these borrowers were influenced by a new breed of financial planners and mortgage brokers who promote the view that unused equity should be used for investment -- in common stock, other property or annuities.
Some homeowners used the growing equity in their homes as a way to live beyond their means. They would build up credit card debt, then consolidate the debt into their mortgage through a cash-out refinance. The consolidation, by extending the term of the credit card debt, reducing the rate and making the interest tax-deductible, would reduce the total monthly payment. They could then start building up their credit card debt all over again.
This process could continue only as long as their houses appreciated. As soon as appreciation stopped, they were stuck with debt service costs that might be unmanageable or with negative equity in their houses, or perhaps both.