With the smoke clearing from the dot-com bubble, the early 2000s were an exciting time for the US housing market, fueled by rising demand and seemingly limitless funding. Investors were looking for new investment opportunities after the tech bubble, which they found in the form of loans to high-risk homebuyers known as subprime mortgages.
During this period, the housing sector was the cornerstone of a strong economy, accounting for 40% of all new jobs created. Housing starts had more than doubled from an average of 609,000 a year in 1995 to over 1.2 million in 2005. Diego and Washington, DC, prices rose more than 80%. This was an era of low interest rates and expanded credit for homebuyers. The home ownership rate, particularly among first-time buyers, rose to as much as 69%.
Who was behind this unprecedented funding? Believe it or not, there was a global impact. Banks approved mortgages and then bundled them into interest-bearing packages known as mortgage-backed securities. The riskier, higher-yielding securities, known as “private labels,” were then sold to investment banks and traded at a profit around the world.
In the early 2000s, subprime loans were a newly introduced mortgage category. They made it possible for buyers with less than perfect credit (FICO scores of 600 and below) to afford a home of their own.
These homebuyers made payments at much higher monthly rates than others with better credit ratings, compensating lenders for their increased risk.
Here are some types of subprime mortgages:
Between 1995 and 2001, subprime mortgage origination skyrocketed from $65 billion to $173 billion. 80% of subprime loans were adjustable rate mortgages that contained a mix of the above features.
Subprime mortgages gave the impression of affordability but often included hidden fees. In addition to the variable interest rate, subprime borrowers had other additional costs – sometimes even increasing the principal over time.
Subprime lending was three times more common in low-income areas. Predatory lenders used unfair or discriminatory practices to persuade borrowers to take out mortgages they could not afford. Minorities were often targeted: Latinos and African Americans were 2.8 times more likely than whites to be offered a subprime loan, according to data from the Home Mortgage Disclosure Act. Ohio Assistant Attorney General Jeffrey Loeser described how predatory lenders even went door-to-door, selling subprime loans to consumers they didn’t understand.
It’s easy to see why there’s been so much confusion surrounding subprime adjustable rate mortgages – they’re quite complex.
The name of an adjustable rate mortgage gives clues to its terms:
After the teaser period, the ARM saw an initial adjustment, typically 2%. This meant that after the original rate, the new rate would be a maximum of 2% higher. In addition, there could be subsequent adjustment periods, each with their own maximum percentage increase.
And to top it off, the mortgage lenders added another indexed rate to the total interest rate, which included a margin of typically 1%. For example, take a 5/1 ARM with a 1% lender index and a 2.75% margin. After 5 years, the new overall rate adjusted 2% higher would be 4.75%. But let’s say the margin was 5%. In this case, the new overall rate would be 7.75% – quite a jump!
If you had a $300,000 3/1 ARM in 2002, the initial interest rate would have been around 5% and the monthly payment would have been around $1,610.
In three years, when the ARM was initially adjusted, the new rate would have increased to a 7% rate, totaling $1,995 per month. That’s a difference of $385 per month, or $4,600 more per year.
And that was just the first adjustment.
All too often, lenders failed to prepare their customers for what would happen after the teaser period or in the event that prevailing interest rates rose. Subprime homeowners just couldn’t afford to keep up; as a result, many defaulted on payments.
Speaking of interest rates, between 2004 and 2006 the Federal Reserve monitored inflationary pressures and took action to correct them, raising the fed funds rate 17 times from 1.0% to 5.25%. As interest rates rose, banks had to pay more interest to depositors, so interest rates on ARMs and other categories of subprime mortgages had to be adjusted higher as well.
Subprime mortgage holders were in trouble.
Millions of US homeowners in metropolitan areas such as Detroit, Las Vegas, Miami and San Jose defaulted on their loans. Florida and California were hit particularly hard. By 2007, lenders had foreclosed on 1.3 million homes, with another 2 million in 2008 – and more to come. As of August 2008, over 9% of all US mortgages were either past due or in foreclosure.
If you’re wondering why subprime borrowers couldn’t just refinance their loans, the problem was that home values also fell during this period. Mortgage-backed securities contained thousands of subprime mortgages, and when the market collapsed, so did their bond funding. These securities received credit downgrades, making them less attractive investments. This, in turn, caused lenders to stop approving risky mortgages, lowering demand for housing and causing house prices to fall.
It was like a set of dominoes.
First, New Century Financial Corp., a large subprime mortgage lender, filed for bankruptcy. Then agencies like Fannie Mae and Freddie Mac, whose job it was to make homeownership affordable, suffered staggering losses on outstanding loans they had allocated to mortgage-backed securities. The federal government had to rescue them in 2008.
Even investment banks became vulnerable as they could no longer raise funds in the securities markets. Lehman Brothers filed for bankruptcy on September 15, 2008. A global financial crisis was underway.
The subprime mortgage crisis sent the economy into a tailspin: unemployment rose and GDP fell. Consumer spending slowed and liquidity eroded. The United States entered the longest recession since World War II, known as the Great Recession, which lasted from December 2007 to June 2009.
In 2010, the US Congress approved $700 billion under the Troubled Asset Relief Program, or TARP, to inject liquidity into the markets, and the US Treasury Department provided billions more to stabilize the ailing banking industry. Through this program, banks were encouraged to revise payments on mortgages that were “under water” rather than seek foreclosure. Homebuyers got temporary tax credits, and the Federal Housing Administration increased the amount it could insure on mortgages.
Between 2008 and 2014, the Federal Reserve cut interest rates to almost 0%. It also initiated a series of quantitative easing measures to increase the money supply and boost credit until employment levels rose again, and provided additional government support to stabilize sectors such as the US auto industry.
Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in 2010 to reform the financial industry and prevent another crisis, a new regulator was created: the Consumer Financial Protection Bureau. The aim is to regulate the banking industry more tightly and protect consumers from discrimination, including predatory lending. A section of Dodd-Frank known as the Volcker Rule prohibited banks from trading speculative assets such as risky, high-yield derivatives.
Nonetheless, subprime mortgages still exist today – they are now known as Nonprime Loan. Fortunately, their structure is less complex than their historical counterparts; Also, most now have rules that allow variable interest rates to be adjusted lower as the homeowner’s creditworthiness improves.
The ARM share of the housing market has fallen dramatically; They account for less than 10% of residential mortgage loans today.
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