The Mortgage Professor

Unearthing the Roots of the Subprime Problem

By Jack Guttentag
Saturday, May 19, 2007

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?

  • End of price appreciation. The immediate cause of turmoil in the subprime market was the end of house-price appreciation. Property values in most areas stopped rising in 2006, and in many places, they have declined. This has led to a rise in delinquencies and defaults on what I call "appreciation- dependent mortgages," or those that worked for borrowers only if their properties increased in value. A large proportion of such mortgages were subprime.

  • Speculative purchases. Some houses were bought with 100 percent loans by borrowers hoping to turn a quick profit from appreciation. These loans were made for the full amount of the purchase price or appraised value -- no down payment was required.

    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.

  • Speculative refinances. A presumption that house values will appreciate also affected the refinance decisions of many borrowers. One question that house buyers asked me in 2004-05 with distressing frequency was, "How long do I have to wait after purchase before I can refinance to take cash out?"

    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.

  • Unaffordable mortgages. The most commonly used mortgage in the subprime market is the 2/28 ARM. This is an adjustable-rate mortgage on which the rate is fixed for two years and is then reset to equal the value of a rate index, plus a margin.

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