Subprime mortgage market dynamics and impact

Subprime mortgage market was an important segment of the mortgage market in the 1990s and early 2000s. Subprime mortgages rose from approximately ten percent of the mortgage market to twenty percent in 2005 and 2006 however, the market has experienced a hardship since late 2006 and early 2007. In the fourth quarter of 2007, 17.31% of subprime loans were delinquent and 8.65% of subprime loans were in the foreclosure process. The work of Dell-Ariccia, Igan and Laeven (2008) entitled: "Credit Booms and Lending Standards: Evidence from the Subprime Mortgage Market" states that the subprime market has "expanded rapidly" over the past ten years and has evolved "from a small niche segment to a major portion of the U.S. mortgage market." (Dell-Ariccia, Igan and Laeven, 2008) While there is not a definition for the subprime market that is written in stone "the classification 'subprime' generally is a lender-given designation for loans extended to borrowers with some sort of credit impairment, say, due to missing installment payments on debt or the lack of a credit history." (Dell-Ariccia, Igan and Laeven, 2008) Dozens of subprime lenders went bankrupt or were acquired. Many other lending firms have dramatically cut down their subprime portfolios, or have stopped making subprime residential loans altogether. This work will compare the subprime loan as compared to prime loans. What are the common tools used by subprime lenders and what are the common tools used by subprime lenders are questions that will both be answered as well as answered will be the question of the benefits that subprime mortgages create for homeowners. Finally this work will answer to the potential problems of subprime lending and will seek to identify the factors that contributed to the subprime market growth and to understand the reason behind the subprime bust. As well this work will seek to understand how the subprime mortgage financial crisis impacted the financial services industry in general and the insurance industry in particular. Lastly, what were the responses to the problems in the subprime markets from the legislators, regulators and the lending industry to prevent future crisis and will state recommendations.

I. DEFINING the SUBPRIME MORTGAGE

The work of Ronald Utt (2008) entitled: "The Subprime Mortgage Market Collapse:

Primer on the Causes and Possible Solutions" states that the subprime mortgages are generally defined "....in terms of the credit bureau risk score (FICO) of the borrower. Other credit imperfections...can also cause borrowers to be classified as subprime for a particular loan. For example, the addition of the mortgage loan might increase the borrower's debt-to-income level above traditionally prudent thresholds." Utt additionally relates that what bank supervisors look for in the subprime mortgage market are the following characteristics to avoid: (1) recent; (2) Recent payment delinquencies (30-day or 60-day depending on recency); (3) Judgment, foreclosure, repossession, or charge-off within prior two years; (4) Bankruptcy in last five years; (5) Relatively high default probability (FICO below 660 or similar measure); (7) Limited ability to cover living expenses after debts (debt-service-to-income ratio of 50% or more)." (2008) Sometimes the industry lumps subprime loans into the general class of nonprime loans because of some specific feature of the loan arrangement, such as limited or no documentation about income or assets, high loan-to-value ratios, high payment-to-income ratios, the purchase of a second home, or some combination of these characteristics." (Dell-Ariccia, Igan and Laeven, 2008) Subprime mortgages can have either fixed interest rates or adjustable interest rates. Interest rates on adjustable rate mortgages (ARMs) are pegged to a benchmark rate, such as the six-month Libor rate or the one year Treasury bill rate." (Dell-Ariccia, Igan and Laeven, 2008)

One of the primary features of the subprime ARM is an interest rate in the beginning that is lower than present rate. This rate is fixed for a specified time period and then resets to the index rate. Innovation in housing finance in combination with the rise in subprime lending and the added an overall boom in housing. The housing market exploded in growth due to the demand for housing and since mortgage access was easier with "underwriting standards on mortgage debt ease. Looser standards included a general increase in loan-to-value ratios, less stringent debt to income requirements, and a willingness on the part of lenders to accept limited or not documentation of borrowers' income and assets." (Dell-Ariccia, Igan and Laeven, 2008)

II. BENEFITS of the SUBPRIME MORTGAGE

The work of Utt states that the subprime borrowers increasingly used what is termed alternative mortgage products that had been utilized "primarily by sophisticated investors." (2008) Prior to the middle of the 1990s the use of subprime and risky mortgage products was not common however in 2001 "...newly originated subprime, Alt-a, and home equity lines (second mortgages or "seconds") totaled $330 billion and amounted to 15% of all new residential mortgages. Just three years later, in 2004, these mortgages accounted for almost $1.1 trillion in new loans and 37% of residential mortgages. Their volume peaked in 2006 when they reached $1.4 trillion and 48% of new residential mortgages.: (Utt, 2008)

During the same period of time there was collaterization of mortgage backed securities (MBS) by subprime mortgages which had started in 1995 at $18.5 billion to $507.9 billion in 2005. A great deal of this expansion is attributed to the increase in the use of these type mortgage products by those with credit records that were 'less-than perfect, modern incomes, and/or limited wealth to access the credit to buy a house or refinance an existing home." (Utt, 2008) During this time as well the percentage of individuals who were homeowners also grew. Prior to World War II home ownership was low but rose "steadily from 44% in 1940 to 62% in 1960 to about 64% in 1970, where it remained until 1995." (Utt, 2008)

Homeownership is stated by Utt (2008) to have "...jumped from the 64% that characterized the previous 35 years to record levels at or near 69% between 2004 and early 2007." (2008) Benefits of the subprime mortgage included the "building and financing boom that took the homeownership rate to record levels. New housing unit starts (single and multi-family) reached 2,068,000 units in 2005, compared to an annual average of about 1.4 million starts during the 1990s. In 1972, generous federal subsidies propelled the market to unsustainable levels and the all-time record of almost 2.4 million new units." (Utt, 2008)

Resulting from the boom in the housing market were "construction workers, mortgage brokers, real estate agents, landscapers, surveyors, appraisers, manufacturers and suppliers of building materials, and many other professions and businesses" that saw record levels of activity and incomes. This activity, in turn, flowed through the rest of the economy during the first half of this decade, contributing to the expansion that began in 2001." (Utt, 2008) the year 2005 is stated to be the 'peak' of all the activity in the housing market in terms of subprime loans. At the same time risky loans were being financed, home prices were escalating in many markets and land-use regulations were very strict and resulting in housing being unaffordable for may. Defaults in the subprime market are stated to have began to emerge "...often after just one or two payments revealing a pattern of fraud in such transactions." (Utt, 2008)

These problems grew more exacerbated and the home values fell and in 2006, the values "fell sharply" and price escalation ended in many housing markets regionally. Utt states that additional default occurred due to the fall in home values because individuals in the subprime industry was characterized by "...borrowers had assumed that perpetual home price increases would allow them to refinance their way out of onerous loan terms, including the scheduled "resets" to higher monthly mortgage payments. A growing number of borrowers who had used subprime mortgages and/or seconds to buy at the peak of the market with 100% financing found themselves carrying debt loads that exceeded the values of their homes, making refinancing impossible. It also made selling the homes largely impossible because the proceeds would fall short of outstanding debt, forcing the owners to cover the differences out of other financial resources, which many did not have." (Utt, 2008)

III. SUBPRIME MORTGAGE FALLOUT & the ONGOING BOOM in LENDING

The work of Utt (2008) relates that new home sales begin its decline following 2005 and that the sales of homes "peaked [at] 7,076,000 units in 2005 and fell to 6.4 million units in 2006 and then fell to a seasonally adjusted annual rate of 5 million units by February 2008 - nearly 0% below the 2005 peak levels." (Utt, 2008) Simultaneously the mortgage default and foreclosure rates rose and hit the highest levels witnessed in quite a few years. At the same time all of this was culminating Utt (2008) states that the subprime market "also boomed" which reflected the "fast growth of fresh, new (and untested) loans. Utt (2008) state that the "current market collapse has been due to the largely 'unregulated residential mortgage market."

IV. TYPES of SUBPRIME MORTGAGES

There are several types of subprime mortgages including those as follows:

Adjustable-Rate Mortgages. The term "adjustable-rate mortgage" describes any mortgage with an interest rate and payments that adjust according to some formula agreed upon by the borrower and lender. ARMs have been generally available to borrowers for about three decades on prime mortgages, but variants have been common to subprime mortgages over the past 10 years. The traditional ARM linked the mortgage's interest rate to the LIBOR plus several percentage points." (Utt,2008)

Alt -- a Mortgages. Sometimes referred to as a "low-doc" mortgage, an Alt -- a mortgage is structured like the other mortgages described in this section but is made available only to prime borrowers or those with FICO scores above 660. However, these prime borrowers were required to offer only limited documentation on their qualifications, so many may not have been as "prime" as they represented themselves to be, as subsequent default rates indicate." (Utt, 2008)

Extremely Low- or No-Down-Payment Mortgages. As home prices appreciated and as mortgage originators and lenders looked to expand their pool of potential customers beyond those with sufficient savings and net worth to make the required down payment (generally 5% to 20%), lenders and investors began to offer and buy mortgages with little or no down payment. Sometimes they provided more than 100% financing by allowing buyers to borrow a portion of their settlement costs." (Utt, 2008)

Interest-Only Mortgages. Most mortgages today are fully amortized, meaning that each monthly payment covers both the interest and a portion of the principal. Over the life of the mortgage (typically 30 years), the principal amount will gradually be paid down to zero. (Utt, 2008)

Negative-Amortization Mortgage. A negative-amortization mortgage is much riskier than an interest-only mortgage because the initial payments do not cover all of the interest, so the interest deficiencies are added to the loan's principal, which increases over time along with the borrower's indebtedness. Once the flexible payment period ends, the monthly payments are even larger because the loan amount has increased and the amortization period is shorter. Risks to the lender are more severe than the risks that are encountered with interest-only mortgages." (Utt, 2008)