Subprime mortgage market crunch
By Charles Hopkins
Published 01/2/2008 | Real Estate
The so-called subprime mortgage market crunch has been headline news in
recent months and there is no sign of the problem abating in the near
So, what is the subprime crisis all about?
A subprime borrower is basically any borrower who does not qualify
for "prime" lending rates. Many factors could contribute to this
status, including low income or the inability to provide full
documentation to satisfy lending criteria of prime lenders. However,
most commonly subprime borrowers are those whose credit scores are
lower than prime lenders consider acceptable. In general subprime
borrowers will have credit scores lower than 650-620. The proportion of
subprime borrowers in the mortgage market has increased considerably
over recent years. It is estimated that subprime borrowing accounted
for only around 5% in 1994. However, by 2006 it accounted for 15% of
all mortgage borrowing.
Typically subprime borrowers with lower credit scores are
considered higher risk. Lenders in this market were willing to take on
the increased risk in return for higher rates than prime lenders. With
the rapid growth in this market many people who were previously unable
to access credit were able to obtain home loans but at significantly
higher rates. Most of the loans were written with an initial
"honeymoon" or "teaser" rate - fixed for the first two or three years.
This fixed rate would be considerably lower than the variable rate that
applied for the remaining period of the loan. In the heyday of the
subprime market a typical subprime borrower would take out a loan for
say 30 years with a lower fixed rate for the first 2 to 3 years. At the
end of this fixed rate period the property would usually have increased
in value and there would be a multitude of other lenders willing and
able to refinance the loan and offer a further fixed "honeymoon" rate.
However, things started to go wrong when increasing numbers of
subprime borrowers found themselves over extended and defaults began to
increase. Subprime borrowers who had intended to refinance their loans
at the end of their lower fixed interest term found it increasingly
difficult to do so. Defaults skyrocketed leading to an increased supply
of properties coming onto the market. This in turn depressed prices
leading to lower security value when trying to refinance. The problem
started to spiral out of control. A combination of reduced liquidity
and fewer lenders willing to lend to the subprime market or refinance
mortgages meant that more and more defaults occurred fueling even more
problems in the market.
The first step for many caught up in this crisis and facing
increased interest rates is to try to avoid foreclosure. To this end
the Federal Reserve has cut interest rates and provided a massive
injection of liquidity to prop up the market. The mortgage industry has
also come under increasing regulation to protect borrowers from
predatory lending practices. Regulations also aim to ensure that
lenders are flexible with borrowers and work together to minimize
foreclosures. Some other suggested solutions have been to keep interest
rates fixed at "teaser" rates for any borrowers that have not defaulted
during their teaser period. This recommendation has not been well
received by the mortgage industry. Yet another suggestion is to
increase the maximum value of mortgages that can be insured from the
current limit of 417,000 to 1 million.
Despite these steps many hundred thousand households are expected
to face considerable hardship in the months and years to come - a large
proportion of which will end in foreclosure.