The Real Casualties of Subprime Lending

by : David Dinkel

Subprime lending has recently caused over 56 lenders to either go out of business or stop issuing subprime loans because of excessive foreclosure rates. The lending community made decisions in the last few years that dramatically eased a borrower's qualifications with a resultant dramatic increase in foreclosures.

The housing demand was so strong that lenders started to compete for the insatiable mortgage demand by making qualifying very easy. One example was the creation of the "stated income" loan, or the "liar's loan". In the loan application, the borrower only had to "state" his income without showing any proof of that that income. Unfortunately about 60% of borrowers over-stated their income on their loan applications to qualify for their loans. A review of lending practices showed racial disparities in African-American and Hispanic low-income neighborhoods which had 1 ? times as many subprime loans at higher interest rates and closing costs as compared to low-income white neighborhoods.

The lenders planned to compensate for higher default rates by charging higher interest rates and closing costs. But to make payments as low as possible for the borrowers, lenders developed low-initial interest rate loans (teaser rates) or negative amortization (Neg Am) mortgages. With a Neg Am loan, a borrower would actually owe more than he originally borrowed when he went to sell.

The teaser rates combined with adjustable interest rates caused borrowers to be hit with huge mortgage payment increases. Most borrowers couldn't afford huge monthly payment increases and foreclosure rates began to rise. Lenders gave the loans on the assumption that the homeowner would do whatever necessary to make the payments, or the lender would get the property back in foreclosure and re-sell it for a profit in 'hot real estate" markets.

Overlooked by lenders was the fact that real estate investors had become a major factor in the real estate market that had previously been dominated by the 'retail buyers" or single family homeowners. The actual statistics went from investors owning about 2% of all single family homes in 1990 to almost 28% in 2006. This huge increase in investor ownership caused the "tail to wag the dog" and sent the real estate market into price advances that exceeded historical stock market gains.

Lenders were not discouraged, and to make loans even more affordable, developed 100% financing loans designed to eliminate "PMI" or Principal Mortgage Insurance by using an 80% first and a 20% second mortgage. This 80/20 program was so successful that it became the standard loan for most new homeowners for an 18 month period in 2003 - 2005. Now the borrower had two mortgages, the first at a traditional interest depending on the borrower's credit rating and a second mortgage with a higher interest rate of 3% to 5% above the first mortgage rate.

We are now seeing huge default rates among 80/20 financings because the borrowers saw an opportunity to refinance their properties, cash out an equity profit without having to sell their homes, and just walk away without making any mortgage payments.

Who are the losers? Unfortunately, anyone with an adjustable rate mortgage who can't convert it to a fixed rate, investors who own mortgaged properties, new homeowners with challenged credit or minimal down payments, the support personnel for the real estate industry, including realtors®, construction personnel, construction support industries, mortgage brokers and their staffs, lenders and their staffs, attorneys who specialize in real estate law, appraisers, surveyors, home inspection personnel, and just about anyone in a support industry related to real estate.

There are solutions, but barring governmental intervention, the average homeowner needs to focus his financial future on getting a fixed rate mortgage; trimming his expenses where possible; taking advantage of his property tax exemptions for homestead, military service, or senior discounts; be proactive in selling his home and slow to replace it with another home; stay away from "funny money" loans that could escalate sharply; and save cash for a larger down-payment to reduce his interest rate and monthly payments. As bleak as the future appears for many economists, the financial markets have weathered worse financial storms. I suspect the final solution will take years and need the banking industry to become more pro-active is the resolution of the individual homeowner's financial problem. An alternative solution involves the lending institutions developing a strategy of better handling of the re-sale of the bank owner properties by offering them directly to new homeowners by a national bidding system, involving all the lenders.