Subprime Mortgage Crisis

Subprime Mortgage Amounts

In 2002, subprime mortgage originations totaled about $200 billion or 7% of the mortgage market.

Three years later these originations on these loans grew to over $600 billion or 20% of the market.

Subprime mortgages generated the highest fees to the predatory lenders.

Subprime Mortgage Characteristics

Adjustable rate mortgages (ARMs) are loans whose interest rates adjust up or down with changes in the Fed Funds rate.

Typically subprime loans were a hybrid 2/28 or 3/27 instrument.

Subprime Teaser Rates

The mortgage rate is fixed for the first two years or three years and then switches to an adjustable rate for the remaining life of the mortgage.

One-third of ARMs taken out between 2004 and 2006 began with "teaser" rates below 4%.

Historically Low Interest Rates

US Federal Reserve lowers Federal Funds Rate 11 times, from 6.5% (May 2000) to 1.75% (December 2001).

The Fed Funds rate bottomed out in 2004 at 1%.

This created an easy-credit environment that fueled the growth of subprime mortgages.

Higher Interest Rates

Subprime loans have interest rates 3% to 5% points higher than prime mortgages.

These mortgages also have higher points and fees, and when these are factored in, the average subprime loan often has double digit interest rates that are 4% to 6% points higher than prime mortgage of similar terms.

Subprime Mortgage Holders Hit Twice

The Fed Funds rate went from 1% in June of 2004 to 5.25% in June of 2006.

The variable portion of the mortgage would kick in after the fixed two or three year period, causing payments to dramatically increase leading to increased defaults.

Refinancing Troubles

When 2/28 and 3/27 mortgage teaser rates ended, borrowers had a reason to refinance before their interest rates jumped.

However, about 80% of subprime mortgages had prepayment penalties, where only 2% of prime loans did

Ability to Pay

The standard test for the ability to make payments is the mortgage payments, taxes, and insurance should be no more than 30% of gross income

With subprime mortgages, this number approached 60%.

Delinquency Rates and House Prices

Delinquency rates on subprime adjustable rate mortgages skyrocketed from about 12% in 2007 to about 36% at the end of 2008.

This led to a rapid loss in home values starting in 2007. In 2008, prices fell by 20%.

Housing prices rebounded slightly in 2009, with the $8,000 first-time home buyers tax credit.

Prices started to fall again when the credit expired.

Securitization

Many subprime loans were securitized (bundled and sold as an investment).

Securitization allows for credit risk to be transferred from banks to investors.

The financial crisis took place because banks did not follow the securitization business model and became investors in Mortgage Backed Securities.