MoreBangForMyBuck

MoreBangForMyBuck Articles

HOME : Articles : Articles/the Subprime Bogeyman

The Subprime Bogeyman

Is There Anything Redeeming to this Infamous Lending Practice?

Subprime mortgages have been, somewhat rightly, blamed for the recent economic troubles. But the collapses in the banking system cannot be blamed entirely on them. Subprime loans are a tool, of sorts. Like any tool, they can be used for bad or for good. Alas, they were used, at least in part, very irresponsibly. To know how, you need to understand what a subprime mortgage, or more broadly, a subprime loan, is.

A subprime lending is the issuance of loans to what are considered the highest-risk cases. This is due, generally, to some combination of the borrower's credit rating, the ratio of loan size to the value of the collateral, the ratio of loan size to the income and assets of the borrower, the loan's structure, and whether the documentation provided is conforming or non-conforming. When a loan is “conforming”, it means merely that the documentation provided meets Fannie Mae or Freddie Mac guidelines for prime mortgages.

After the mortgages were issued, they didn't stay with the issuers. They were bundled and sold to investors in a form similar to bonds.  

Subprime mortgages were issued with wild abandon during the housing boom, in part because, with the ridiculous notion that house prices only go up, the lenders figured the collateral would easily compensate them if the borrower failed to make their payments, which subprime borrowers were far more likely to do. This was the start of the problem, but not the end of it.

After the mortgages were issued, they didn't stay with the issuers. They were bundled and sold to investors in a form similar to bonds. As such, the mortgage issuers really were just middlemen, who made their commissions, sold the mortgages for less than the anticipated rate of return, and thus avoided any of the risk associated.

Why would an individual or institution buy such a thing? Because even if a subprime loan, in and of itself, might carry a 15% risk of default, and thus have its value drop to a small fraction of the original anticipated value of principal plus interest, a bundle of 100 such mortgages, while it would be likely to lose perhaps 10% of its potential value, could still seem a worthwhile investment if sold for less than 90% of that potential value, which would still be far more than the loan amounts. Given the potentially high returns that the generally variable-rate loans, and the supposedly one-way direction of home values, they appeared to be both profitable and safe.

Indeed, so safe did they appear, that the institutions that bought them often used them as collateral in taking out their own loans, and other institutions were willing to offer insurance on them, the shadowy credit default swaps also frequently mentioned when explaining the financial catastrophe.

All this is to say that a very, very large amount of money, in the end far more than the value of the subprime mortgages themselves, was invested in them, dependent on the idea that they would continue to rise in value. When they didn't, therefore, a far larger disaster precipitated than would have been possible if the subprime loans themselves were the only problem.

So, it wasn't really the subprime loans that were disastrous, but what was done with them. A subprime loan can allow you, if you are a borrower with a low credit score, to get into your own home, a prospect that would be impossible without them. They can be a very good thing. However, they do require caution from both the borrower and lender. You must be sure that your position going into the future will be strong enough to afford your payments, keeping in mind that you will be paying a higher rate of interest than you would on a prime loan of the same type. In other words, you will pay more for the same house than another might. Lenders are being very cautious these days, having been burned by taking risks in the past, and so you will have to provide ample evidence that you will, indeed, be good for your debts. Still, if there is a house you've had your eye on for awhile, if you want to stop renting and start owning, a subprime mortgage may be just the thing you need.

The Daily Bang