Stories about the subprime crisis are in the news daily. It has led to falling proprety prices, a slowdown in the economy, and billions in bank losses.
But do you really know what subprime means? What effect has it had in Los Angeles? What challenges does it present, even to those with excellent credit? What opportunities does it reveal?
To answer these questions, let’s start at the beginning…
Understanding Mortgage Lending
Traditionally, mortgages were financed by banks. This meant that a bank was limited in its lending based on the deposits they received from their customers.
Recent changes to this model, however, paved the way for the current situation to arise. Banks moved to a new lending model in which the mortgages they held were sold to the bond markets. This freed banks from lending based solely on their customer deposits.
The boon to this new model was that more money was available to help people buy homes. The downside, unfortunately, was that banks no longer had as much pressure to verify that the mortgages they issued were solid. Knowing that the mortgages they created would eventually be sold, banks took on riskier loans than would have been prudent in the more traditional lending era.
The Mortgage Bond Market
Until recently, the mortgage bond market was heavily dominated by government-sponsored agencies such as Freddie Mac. Since 2002, however, the private sector asserted itself in this market with a vengeance.
With new mortgage vehicles such as jumbo loans, and sub-prime loans to borrowers with poor credit histories and/or weak documentation of income who were rejected by prime lenders like Freddie Mac, the private sector significantly increased its role in the mortgage bond market.
The rise of private sector participation catapulted the mortgage bond market to a worth of $6 trillion, making it the largest part of the $27 trillion bond market. The mortgage bond market is now even bigger than the Treasury bond market.
Foreclosures Emerge
Many homeowners were lured by brokers selling subprime mortgages who explained that the equity in homes could be turned into cash by refinancing. What brokers failed to explain in many cases was that the mortgage interest rates would double after 2 years.
A wave of foreclosures began appearing, first in inner-city areas, then across the entire country, starting in 2005.
By that point, 20% of all mortgages were subprime. They were especially popular among recent immigrants in the competitive housing markets in New York City, Arizona, Nevada, Washington, D.C. suburbs, and Southern California.
Consequences
Foreclosures are predicted to rise over the next two years as many sub-prime mortgages fall outside of their initial 2-year period, causing interest rates to become variable and, in many cases, double. It is estimated that as many as 2.4 million homeowners are in danger of foreclosure because of subprime loans.
The dramatic rise in foreclosures has had such a strong impact on the price of homes that we now see the first national decline in housing prices since the 1930s. A glut of 4 million unsold homes is depressing prices, forcing builders to lower prices to rid themselves of remaining inventory.
The building industry, comprising 15% of the economy, is expected to halve its output, causing a loss of over one million jobs. Related industries such as manufacturers of durable goods, e.g. washing machines, home improvement stores, furniture makers, may also take a hit.
Banks and the bond market are also feeling the crunch. Banks have already lost $60 billion, and bondholders (such as pension funds) who have bought subprime mortgage bonds have seen a sharp fall in value of those instruments. Estimates of the total financial loss for these institutions run as high as $450 billion.
Since lenders have suffered badly, they are more stringent with any new loans they make, resulting in a tightening credit supply for consumers. Mortgages, especially non-traditional ones such as subprime and jumbo loans, are now more difficult to obtain.
Now that the basics are covered, in subsequent wp_posts, let’s answer the questions we originally asked:
- What effect has it had in Los Angeles?
- What challenges does it present, even to those with excellent credit?
- What opportunities does it reveal?
To read more about the subprime situation, check out the following links:
- The Subprime Crisis In Graphics
- Subprime Crisis Timeline
- Wikipedia’s Page on the Subprime Mortgage Crisis