Subprime lending, formerly known as B and C lending, was created to serve a special group of borrowers, those who would not qualify for prime loans carrying the best rates in the market. Prime loans were offered to those who could make a twenty percent down payment, obtain mortgage insurance, or government guaranty, and whose credit was very good to excellent, and whose income and assets were easily and traditionally verifiable. Subprime lending was created for those whose credit and income situations placed them in the Alt-A, B, C, and later D credit grading system. Subprime lending allowed people who could afford, but not qualify for prime mortgages to become homeowners. The original intent was to allow home owners to build equity and build their credit to prime simultaneously.
Banks, the primary mortgage lender in the early days, also saw a specific need of theirs that could be met through the subprime market. In essence, banks were funding thirty year mortgages with two or five year CDs. How could they return the depositor’s investment when the mortgagor’s loan was not paid off? The answer was to turn all of the mortgages a bank holds into an investment vehicle that could be sold to investors on the market. Most of these loans were two or three year adjustable rate loans with a low starting rate and payment. The plan was that with two or three years of good payment history, a borrower would qualify for a prime refinance before the adjustment period (increase in interest rate and monthly payment) went into effect. This plan worked initially. It worked so well that many investors began offering mortgages to more higher risk, very low to no credit or income, borrowers promising higher yields to investors who participated.
As a result, by 2000 mortgage lending was reaching a high point. In response housing prices began skyrocketing and hit a peak in the fall of 2006. Then the market took a turn and housing prices have been on a steady decline. Suddenly, homeowners were unable to refinance into prime loans as originally intended. The lenders, who were counting on these loans to be paid off early through refinancing, were unable to maintain the promises made to their investors. Selling or foreclosing are not the most viable options because most of the mortgages made during the 2003 to 2006 period are “upside down”, meaning the mortgage balance is higher than the current market value. Whomever sells, the homeowner or the foreclosing lender, will loose money. As a result, many mortgage loans are adjusting to higher rates, many homeowners are defaulting on the higher and unaffordable payments, and many lenders are pursuing foreclosures.
Questionable business practices, namely, predatory lending, have been the primary target of blame for the current mortgage crisis. While unethical practices certainly can and do put borrowers at greater risk for default, one must remember that those practices are not limited to the banks, and that one must separate unethical from standard competitive business practices.
The subprime mortgage meltdown in the result of an economic crisis which is characterized by the constant increase in foreclosure filings across the nation. Research reveals that economic factors such as stagnating incomes and housing prices, along with the natural business cycle as the cause of the current mortgage meltdown.
Most subprime loans are low risk business investments that serve a basic living need – housing. “Our research suggests that nationally, 20 percent of securitized subprime loans had, at origination: favorable loan-to-value (below 90 percent), favorable credit ratings (FICO scores over 620), full documentation and were identified as owner-occupied” (Rosengren, E. S. December 3, 2007) One should not assume from this statement that subprime loans are characterized by high loan-to-value, low credit scores, no income documentation, or were not owner occupied. Most subprime loans have some combination of favorable factors that characterize them as acceptable risk investments for mortgage lenders and investors.
These less than perfect loan characteristics made an opportunity for mortgage companies to engage in niche lending. Minorities, particularly Hispanics, Latinos, and African-Americans, have benefitted from niche lending. A study conducted by Rick Marsico, Director of the Justice Action Center at New York Law School, revealed that New York city’s top 25 lenders included only five commercial banks.(Harmon February 4, 2008) These banks did not have significant presence in minority communities, therefore many residents did not have access to mortgage loans afforded by the Community Reinvestment Act. Other non bank lenders created investment pools, which were later sold on the open market, to fund mortgages for this special needs group. This is no different than the Veteran’s Administration (VA) loan or the Farmer’s Home Loan Administration. The federal government saw a need that was not being met by the traditional banking community and stepped in. In the same way private businesses across the nation have responded to a similar social need – increasing home ownership in inner city neighborhoods.
Consider the effect of the following economic factors. “According to the US Census Bureau, median incomes were $42,228 in 2001 and $48,201 in 2006 or less than a three percent increase per year. In inflation adjusted terms, median incomes in 2006 were actually lower than they were in 2000.” (Vogel, J. H. October 2007) Compound the effect of falling incomes with rising housing prices. “ From 2000-2005 housing prices across the United States grew at double digit rates each year in most major metropolitan areas.” (Vogel, J. H. October 2007) Ten major metropolitan areas were included in a composite study that revealed that housing prices had increased by as much as 19.87% in 2004 and 16.39% in 2005. The Federal Housing Finance Board ( November 27, 2007) reported that housing prices peaked during the 2005 season, but have spiraled downward through 2007.
National average single family house purchase price (Federal Housing Finance Board. November 27, 2007).
Median incomes were not keeping pace with inflation and housing prices were disproportionately high. In order to afford homes at that point, many buyers opted for subprime mortgages with initially lower adjustable rates. These borrowers were betting on the economy hoping that personal income would rise and that housing prices would continue to soar upward. When those borrowers could not sell or refinance their mortgage loans because they had lost equity of nearly 4% over that three year period.
Here is the real ethical dilemma surrounding subprime lending. If a family can afford to buy a home, but does not meet the guidelines of prime mortgage lenders or existing government loan programs, and if commercial banks who can lend to nontraditional borrowers under the Community Reinvestment Act are not doing business in minority neighborhoods then entire populations are systematically excluded from fully realizing the American Dream. Subprime mortgage lenders responded to a social problem with targeted programs and money. While these lenders could raise enough money to fund these loans, they could not foresee or stop the downward turn in income and housing price cycles.
Today several major mortgage lenders have been forced out of business and into bankruptcy. Loan servicing companies are aggressively pursuing foreclosures to at least retain and hold a property in hopes that the housing market will turnaround so they can sell and recoup their losses. Homeowners are filing bankruptcy to get reduced and affordable repayment plans while waiting to sell or refinance under more favorable market conditions. What began as an economic situation has escalated into a legal situation. Economic situations of this magnitude always attract the attention of policymakers and legal situations of this magnitude always attract the attention of lawmakers. The order of business today and the agenda for tomorrow is about setting policy and passing laws to turn the subprime mortgage crisis around while being careful to not to return to a system of excluding minorities from the dream of home ownership . Also on the agenda is to determine who will have the most success in turning the crisis around; the federal government, the mortgage industry, or the natural effect of the economic cycle.
Dennis, M. W. & Pinkowish, T. J. (2004). Residential Mortgage Lending: Principles and Practices (5th ed.). Thomson South-western.
Federal Housing Finance Board. (November 27, 2007). Federal Housing Finance Board Reports OctoberAverage House Price of $295,573, (MIRS 07-23). Retrieved December 5, 2007, from http://www.fhfb.gov/GetFile.aspx?FileI D=6606
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Vogel, J H (Oct 2007). Cleaning up the subprime mortgage mess. Real Estate Finance, 24, 3. p.23(7). Retrieved March 05, 2008, from General OneFile via Gale:
Mintz, P. (Feb 25, 2008). The Post-Bubble Curriculum; For business schools, the subprime meltdown has become a can’t-avoid classroom topic — at least for now.(IDEAS & INNOVATION). Business Week Online, p.NA. Retrieved March 05, 2008, from General OneFile via Gale:
Harmon, J. (Feb 4, 2008). ‘Minorities More Likely to Have Subprime Loans’. National Mortgage News, 32, 18. p.16. Retrieved March 05, 2008, from General OneFile via Gale: