Subprime Loans - Playing Against the House

A subprime mortgage used to be an alternative for borrowers who did not fit standard guidelines. Maybe they just started a new business or had some past credit problems. These borrowers paid a high interest rate or put more money down to compensate the lender for making a risky loan. Private investors who were willing to accept higher risk for higher returns funded these loans.

In recent years we began to see a new type of subprime loan. It was intended to enable a lot more people to buy homes, and indeed it did accomplish that. It achieved such popularity that, from 2005-2007, this subprime loan accounted for one-third of all mortgage loans issued. Borrowers often did not fit the standard qualification profile. They had issues such as: minimal job history, debt repayment problems, low FICO scores, previous bankruptcy, sketchy documentation, or little cash on hand.

A typical scenario was to start with a very low rate for the first two or three years. Or, the payment was set artificially low, so that the loan balance went up each month, absorbing the unpaid interest. After two or three years a very high rate would begin.

How was it possible to make loans such as these? What made them work? The underlying strategy was this: Instead of relying on the credit worthiness of the borrower, the lender expected to refinance the loan after a short period of rapid appreciation. The refinance requirement was the feature that distinguished these loans from prime or old subprime loans.

The low initial rate was not profitable to the lender. The loan needed to reach its refinance phase to become profitable. A hefty pre-payment penalty discouraged borrowers from paying the loan off early. Squeezed between a pre-payment penalty and an impending high interest rate, the borrower had no choice but to re-finance after the initial two or three years. At that time the borrower could apply for a prime loan - if payments had been made on time, and if their financial condition improved, and if the house had good appreciation.

In fact, most borrowers did not get a prime loan at refinance time. They got a new subprime loan, doubling the requirement and the cost of refinancing. Refinance fees could be added to the loan balance. The lender had a lot of control over the borrower at refinance time. For subprime borrowers, refinancing was not a choice made at their discretion, as it is with prime loans. It was an integral part of the subprime loan.

One could say that this subprime loan was, in effect, an agreement to allow mortgage lenders to play the real estate market - betting all their chips on appreciation.

Why did borrowers agree to this? Borrowers saw their neighbors buying houses, using subprime loans. And it is true that home values were rising, from about 1998 through 2006. In many parts of the country homeowners saw 25 - 50% escalation in their home values. So it seemed to be a safe bet. However, one could say that it was, in effect, a massive pyramid scheme. The more people who participated, the more the early players were rewarded. Demand for houses raised prices, and higher prices stimulated more people to get subprime loans.

Why did investors buy these loans? Subprime loans were financed through complex securitization structures, with multiple levels of risk spread over many parties. Insurance protection could be purchased, shifting the investor's risk to other entities. The layers of complexity were astounding. The investment bankers who created the structures were the only ones who seemed to understand them.

Unfortunately, investors did not know very much about what they were buying. They trusted rating agencies and investment bankers to protect their interests. Yet, no one at any level seemed to understand how dependent subprime loans were on market appreciation. They did not recognize the need to refinance under better market conditions that was implicit in the loan. It was this need for rapid market appreciation that made their investment a very high risk - in fact, doomed to failure.

When the potential downside became apparent to investors, the ownership of risk within complex mortgage securities was very hard to figure out. There was confusion, and then the worst possible reaction - panic. Investments in mortgage securities abruptly ended, investment banks closed, and related financial institutions were harmed. The panic spread, as people pulled their money out of other investments.

Real estate roulette was possible because the borrowers who accepted money, and the investors who supplied money, were not at all clear about the high level of their risk. Had they understood the impending downside, they might have left the table before the game got out of hand.

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