Lenders give a mortgage depending upon the credit score of the borrower. You could either qualify for a prime or a subprime mortgage.
Subprime mortgage was the buzz word during 2008 and 2009. It was the first domino that resulted in the collapse of the economic system of the US betwwen 2008 and 2009. How could a cimple thing like a mortgage cause such a catastrophic chain of events? Let’s find out.
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What Is A Subprime Mortgage?
A subprime mortgage is a type of mortgage that is awarded to borrowers with a sketchy credit history and who are at a greater than average risk of defaulting on their loan. A high-interest rate is charged to make up for the extra risk that the lender takes when he agrees to give the mortgage to a low-credit borrower. Subprime mortgages often have a variable interest rate that can be increased at certain points, hence they are also known as adjustable-rate mortgages (ARM). The 2008 Financial Crises was initiated by unsupervised and widespread subprime mortgage lending.
How Does A Subprime Mortgage Work?
When a borrower goes to get a mortgage, the lender will usually look at four factors to decide whether the loan should be awarded, what kind of loan should be given, and what the interest rate on the loan will be. These four factors include the credit score of the borrower, the number of late payments on the credit report, the amount and type of late payments, and the income of the borrower. Any score below 600 is considered a low credit score and combined with an unreliable work history will automatically translate into a high-interest subprime mortgage. The term subprime refers to the lower credit score and reliability of the loan taker. Lenders pay back the mortgage at either an adjustable interest rate or a fixed interest rate depending on the type of subprime mortgage he takes.
Subprime Mortgage Bonds
A mortgage bond is a bond that is essentially a collection of mortgages that are bundled up together and sold to an investor or bondholder. In return, the investor receives the interest payments on the mortgages paid by the homeowners. If the homeowners default, the investor can sell off the property held in the bonds to make up for the loss. Since these bonds are backed by assets, they are considered safe investments and carry a small rate of return. With subprime mortgage bonds, the yields are higher. Investors get higher returns, as the risk of the mortgage holder defaulting is higher as well.
Subprime Mortgage Crisis Summary
Perhaps one of the biggest economic crises of the 20th Century since the Great Depression of the 1930s, the subprime mortgage crisis led to nine million jobs lost between 2008 and 2009. The US Stock market felt the impact the most – 50% of the stock market fell by early 2009, and the market did not get to its 2007 level until three years later in December 2012. So why is it called the subprime mortgage crisis, how did it start and why did it occur? Let’s take a look.
First, let’s have a quick recap of what a mortgage is. This is because understanding mortgages is a prerequisite to understanding the subprime crisis of 2008-09. To start with, people who wish to purchase a house take a loan known as a mortgage from a bank or a lender with the promise to pay it back in monthly payments with interest. If the borrower defaults on the loan, the lender can sell their house to make up for the remaining payments. Usually, the bank or the mortgage provider gives loans to hundreds of people and needs continuous funds to keep doing so. Therefore, banks or mortgage lenders create mortgage-backed securities to sell to investors so the funds keep coming in. A mortgage-backed security is simply a collection of mortgages bundled together and sold off in categories or ‘pools’ to investors. Securitizing mortgages and selling them to investors results in banks creating a cash flow to fund more mortgages. The investors who bought the mortgages get returns in the form of the mortgage payments that borrowers make per month with interest.
In the past, getting a mortgage was a difficult task. Lenders scrutinized your credit score as well as what job you were doing and your income before they decided to loan the money to you. But these scrutinies started to relax in the early 2000s. This was partly because brokers who sold the mortgages were only concerned with how many of the mortgages they were selling as opposed to what type of mortgage was being sold. Since brokers only received commission depending on how many mortgages were sold, they were not deeply concerned with the terms governing the mortgage. Hence, borrowers with a subprime credit score were allowed to take a mortgage but charged higher interest rates to offset the risk of them defaulting. If the borrower defaulted, the mortgage lender could simply repossess the house. It was a secure loan and the mortgage lenders seemingly had nothing to worry about.
As the demand for subprime mortgages went up, lenders started to securitize and sell the subprime mortgage bonds to investors as secure investments. The mortgage bonds had a much higher yield as compared to the conventional Treasury bonds and were a huge hit with local and foreign investors. Buying mortgage-backed securities was a safe bet for investors – they could sell the homes if the high-risk borrowers are unable to pay their loans.
Since mortgages were being given out so easily, the demand for homes went up. As the demand went up, so did the prices of homes. As the prices went up, the investors became even more confident in their investment. Investors started to buy more and more mortgage bonds. To keep up with the demand from the investors, mortgage lenders continued to issue more subprime mortgages. Credit rating agencies were giving AAA ratings to mortgage-backed securities and so investors confidently kept pouring in the money.
Keep in mind that though mortgage-backed securities and subprime loans had existed in the past, there was no historical data to help creditors predict the effect of subprime mortgage bonds at such a big level. For the most part mortgage debt was a safe and fruitful investment.
All was going well until the low credit borrowers who never had the financial power to pay for these loans started to default. As more people defaulted, banks and mortgage lenders started to foreclose the home. More and more houses became available on the market while there no buyers. The demand for homes and their prices started to plummet. As prices fell, some mortgage owners discovered that they had homes that were worth a lot less than the market price, and stopped making their monthly payments. This led to more foreclosures, and prices continued to fall. Financial institutions and investors stopped buying securities from subprime lenders. Stuck with bad loans and investors refusing to fund them, many big financial lenders soon declared bankruptcy. At the same time, the investors who had initially purchased the mortgage bonds started to lose money as well.
To make matters worse, financial institutions and banks had started to issue an unregulated derivative called a credit default swap (CDS). These were basically marketed as an insurance policy against defaults for investors who were buying the mortgage bonds. Institutions started to issue thousands of these insurances without the money to back them. As a result, when borrowers defaulted and investors went to claim the insurances, the insurers were unable to provide all the money at once. Investors and insurers were suddenly hit hard. Many of these went bankrupt and others had to be bailed out by the government.
What started as a seemingly harmless way to buy a house soon had the entire financial market crumbling. As panic start to set in, trading stopped and the stock market froze. The US economy nose-dived into recession. The overall economy was hurt as contruction and the real estate market fell, reducing wealth, resulting in layoffs and a decrease in overall consumer spending, as well as a decrease in the ability of financial firms to lend money or raise funds through securities.
The government took steps to buttress the falling economy. The Federal Treasury made loans to banks to prevent them from collapsing. It enacted the Troubled Assets Relief Program, known more populalry as bank bailout. It announced $700 billion to help pull banks out of muddy waters, but actually ended up spending $250 billion. TARP also extended its help to auto makers and homeowners. To ease some of the tension in the market, the treasury carried out stress tests on banks and made the reports publicly available. The reports showed which banks had sound balance sheets and which ones still needed to be improved. Since things were transparently laid out, it built trust and removed some of the uncertainties in the market. New laws were passed that progibited financial institutions from taking on too much risk. Slowly, the market re-adjusted itself and had improved considerably by 2012.
Subprime Mortgage Lenders
The subprime lenders faced much stricter regulations after the 2008 recession. Some of the subprime mortgage lenders that were a part of the economic meltdown of 2008 include:
- New Cintury Financial Corporation
- American Home Mortgage Investment Corporation
- Countrywide Financial
- American Freedom Mortgage, Inc.
- NovaStar Financial
- American Equity Mortgage
Subprime mortgages are now being marketed as ‘non-prime’ mortgages. The minimum credit score required by these lenders is 620. Lenders will have different guidelines in deifferent states, so check with your state as well. Below is a list of non-prime or subprime mortgage lenders of 2020:
- Carrington Mortgage Service
- First National Bank Of America (FNBA)
- Angel Oak Mortgage Solutions
- North Star Funding
- Citadel Servicing
- Athas Capital
- Caliber Home Loans
- Green Box Loans, Inc.
Keep in mind that the lender will have stricter checks on your income, and will also charge higher rates and stricter loan terms.
Subprime mortgages are given to borrowers with a low credit score. An abundance of these mortgages, combined with unregulated financial derivatives led to the financial meltdown of 2008 and 2009. The government has since then passed stricter laws to curb these mortgages.