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 future.
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.