What Actually Caused the Subprime Foreclosure Crisis?
Everyone who watches the TV news or reads a daily newspaper knows that mortgage foreclosures are at an all-time high in the U.S. But few truly understand the financial dynamics that set it into motion. That’s because it is a complex issue that came to pass over time and mushroomed into a problem seemingly all at once. Many factions contributed to the problem including lenders, homebuyers and regulators who didn’t act to prevent it before a crisis developed. Now, solutions are being actively discussed but seem elusive in their implementation.
The Growth of Subprime Lending
When lenders realized there was market demand and provided a supply to meet that demand, subprime lending was born. At that point in time, bankruptcy and consumer proposals were widely available, the economy was in a state of flux and consumer loan debt was on the upswing.
Moreover, traditional lenders became extremely cautious and started turning potential customers away in droves. These factors then affected roughly 25% of the U.S. population because they had credit scores lower than 620. Candidly, people with low credit scores became a large potential market for subprime lenders.
It should be obvious that those described above represented prime targets for lenders willing to assume additional risks. Lenders began to utilize a variety of techniques to offset the extra risks they were taking by financing those who were less credit worthy.
Subprime loans were initially made with higher interest rates to offset lender’s risks. These higher rates plus compounded late payment fees resulted in higher overall returns for the lenders. Borrowers of subprime mortgage loans were mostly in the same below 620 credit score category.
They frequently had poor credit histories including delinquencies, charge-offs, judgments and even bankruptcies. These individuals would have been unable to obtain traditional fixed long-term mortgages. Other subprime borrowers included people who didn’t have legal immigration status. Statistics indicate that 26% of all mortgages written between 2004 and 2006 were subprime, compared to just 9% between 1996 and 2004. That totaled some $600 billion in high risk mortgage loans or one fifth of he U.S. home loan market in that year.
Adjustable Rate Mortgages Were The Key Factor In Eventual Mortgage Defaults
Subprime mortgage lenders played a key role in the current foreclosure crisis when they elected to urge subprime borrowers to accept adjustable Rate Mortgages (ARMs). These mortgages deferred high initial monthly payments due to having a lower interest. The problem came from the fact that ARMs carried an annual upward adjustment of the interest rate of 2% or more which increased monthly payments rather dramatically.
This upward rate increase frequently as much as doubled homeowner’s monthly payments, making them unmanageable and resulting in growing arrearages that ended up in defaults. ARMs can also decline, producing lower interest rates when the federal government cuts their prime rate, but they rarely do.
It’s also notable that some unscrupulous lenders went as far as to ‘fudge’ the applications of some loan applicants in order to qualify them for subprime mortgage loans and also to steer more credit worthy homeowners into subprime loans in lieu of the conventional mortgages. As the number of homeowners in foreclosure went up, the crisis developed and has now reach serious proportions nationwide.