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Understanding What Happened With Subprime Mortgages

Feb 7, 2008
After the steep rise in subprime lending in the 2001-2006 period, followed by the credit crunch of 2007, some might ask, "If their borrowers can't pay, why did the lenders make these loans in the first place? Did they not want to be paid back?" To get to the bottom of this question, people need to understand how real estate lending has changed and what motivated the various participants.

Historically, a borrower went to a local bank or credit union when they bought a house. These institutions would typically require 20% or more as a down payment on the property. They would want a borrower to have good credit, documented income, and anything questionable like a collection would need to be cleared up and explained in great detail. A borrower might be able to purchase a home with as little as 10% down, but it would require extra money be paid to mortgage insurance from a highly rated financial institution. Most loans would be sold to quasi-government home loan institutions, Fannie Mae and Freddie Mac, which required strict underwriting guidelines. Loans that could not be sold to these institutions (such as jumbo loans - those exceeding a certain amount) would likely need to stay on that local bank's books, so the underwriting would end up being even more stringent, since a default would impact the bank directly.

Over time, large interstate banks and thrifts such as Bank of America, Wells Fargo, and Washington Mutual grew to dominate residential home lending. Local banks focused more on commercial real estate, small business loans, and other types of loans. While more impersonal, the underwriting was still sound. These institutions starting doing huge volumes of loans, and participating in packaging up and selling big batches of their loans (100 or more) to institutional investors like pension funds, insurance companies, and even hedge funds. These groups had huge appetites for these income-producing investments, especially those that were highly rated as "investment grade" by rating agencies like Standard & Poor's or Moody's. As long as you are packaging up 100 high quality loans, these loans might warrant an investment grade rating. Many financial institutions, however, decided they could greatly expand the amount of loans they could sell by lowering the bar on the underwriting standards. They would simply make loans to people with lower credit ("subprime"). They could also be flexible on documenting income, lax with historical income requirements or down payments, and allow people to obtain loans that they could afford only prior to the interest rate adjusting in the future. However, 100 low quality loans packaged up are not going to get an "investment grade" rating.

That was where the financial engineering came in. Imagine splitting a pool of 100 loans in to fourths: sections A, B, C, D. A was guaranteed to get paid first, then B, then C, then D. If A was guaranteed a certain return (such as 8% interest per year plus the original principal of the loans), even if a certain number of loans went bad, you would still have first priority to the interest and principal on the good loans. A could end up making its return without losing any principal, while D might end up taking a huge hit. Through this financial engineering, even batches of subprime loans could be packaging in such a way that the majority (the A, B, and maybe C) of the sections or "tranches" were considered investment grade and could be sold to a pension fund, while the low grade tranches could be sold to large risk-takers like hedge funds.

For awhile, this all worked out perfectly. Property values were soaring and people made their payments or paid back the loans by refinancing or selling their properties. Everyone involved made money. Then it all stopped. It turns out that people with poor credit eventually start missing payments. Property values started to decline and people owed more on their loan than their house was worth. People could not refinance and many just walked away from their homes. Financial models forecasting the amount of delinquencies and foreclosures were way too low and none of them forecasted a huge decrease in property values. It turns out, all tranches of subprime debt had problems, including the highest rated pieces. Also, many financial institutions like Citigroup and Merrill Lynch that were packaging and selling the loans ended up holding onto some of the lowest rated and now worthless pieces of subprime debt because they could not sell it, as many investors were skeptical of the ratings even before the real estate market started experiencing problems.

So the answer to the question, is yes, the lenders wanted to be paid back. They wanted to keep making money from selling these loans. However, they should have looked to history to know that some loans, no matter how you package them up, should never be made. They probably won't make that mistake again, at least for many years or until they forget the lesson learned.
About the Author
Donald Plunkett is a real estate broker with Congress Realty, a flat fee listing company which serves the states of Alaska, Arizona, California, Colorado, Hawaii, Idaho, Montana, Nevada, New Mexico, Texas and Washington. Donald is a Certified Residential Specialist® and has been licensed since 1994. For more information, please visit Congress Realty.
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