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Subprime Mortgage Lending - A Brief History

Aug 9, 2008
Subprime lending is not really a new phenomenon. The types of non-traditional loans that many subprime borrowers are taking out today have grown from something we used to call a "bridge loan." These were typically very short-term loans with high interest rates that were intended to assist a person to buy a new home while the old home was still on the market. As soon as the old residence was sold, the owner would repay the bridge loan. Some of these non-traditional loans included a "balloon payment," a large amount due at maturity, because they did not amortize fully over the term of the agreement. Monthly payments were relatively low, and the balloon came at the end. The idea was that the person was expected to have sold the first home by the end of the loan, and the large balloon amount would come out of the proceeds.

Another factor in the development of subprime lending as it is today was the gradual deregulation of banks from the mid-1970s to the mid-1980s. Deregulation meant that banks could open branches much more freely, but it also meant that interest rates went sky-high. At one point, average rate of interest was more than 10%. The housing market began to slow, since the interest rate meant that many potential home buyers were no longer within reach of owning their own homes. It was about this time that the subprime adjustable rate mortgage (ARM) came onto the American scene.

A borrower who chose an ARM would probably have sufficient qualifications for the lower rate. As well, private mortgage insurance (PMI) was being offered to buyers so that lenders would be protected if the buyer defaulted. PMI offset the potential loss to lenders if the borrower could not repay the loan, and the lender could not recover his expenses after foreclosure on the house and sale of the property. If you really wanted to buy a house, they were available, but at a cost. Some bankers got the message that they could raise interest rates even higher, increase closing costs and fees, and make an excellent profit from people who were probably not going to be able to repay their loans - if they just assumed more risk.

Banking deregulation meant that new branch banks were on every corner. Money for loans was readily available. And real estate looked like a great way to get rich quickly. Any good-sized social gathering was likely to have one or two new real estate agents in it. There was an astounding variety of seminars and courses on making money by selling real estate.

And of course, as always happens, it changed. Investments that had seemed secure were not; people were losing money. There were new regulations to help us through the real estate crash. Then the wave crested once again: house prices were going up, the market was stabilizing, and here we were in a real estate boom! This time, however, potential homeowners who previously would have been ineligible for loans were able to borrow large amounts of money. Underwriting requirements by lenders slipped; you could borrow money at non-banking institutions as easily as at a bank. Verifying the income of a borrower became less of an issue as lenders hurried to make as many deals as possible with borrowers.

That is a brief outline of subprime lending. The face it has worn for the past decade, and is still wearing today, is very different from the way it looked back in the 1980s, in the deregulation days. Maybe we ought to consider the idea of turning back to the way we used to handle loans. What we're doing now doesn't seem to be helping anyone very much - except perhaps the subprime lenders.
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