- What is a subprime mortgage?
- Why did the banks approve so many subprime mortgages?
- Why is the housing market stagnant?
- Are Fannie Mae and Freddie Mac private corporations or part of the federal government?
- What role did corruption among securities rating agencies play in the mortgage crisis?
- Is the era of the 30-year fixed mortgage over?
What is a subprime mortgage?
A subprime mortgage is a loan granted by a bank to an individual whose credit record suggests they are not a “prime” candidate to repay that loan.
When a bank considers whether or not to approve a loan, officials look at the financial history of the individual requesting the loan. For example, they will evaluate a person’s credit report, job history, and assets.
If an individual’s history does not meet the specified criteria established by a lending agency, they are considered a subprime candidate. Simply put, these individuals are at a higher risk for not repaying their loan.
Sometimes, however, certain economic circumstances will entice banks to approve loans to persons whom they consider to be “subprime.”
Why did the banks approve so many subprime mortgages?
Certain economic circumstances entice banks to approve subprime loans. For example, rising house values mitigate the risk of approving subprime mortgages.
In the first few years of the new millennium, the average value of a home in America skyrocketed. Because of this, houses were great investments and everyone wanted to own one.
Banks approved subprime loans because the rising price of homes offered insurance against defaults. For example, if John Doe defaulted on his loan, the bank would foreclose on the home (meaning the bank now owned the home). The bank could then sell that home for a profit because the value of the home would have risen, offsetting the cost of the loan.
It was worth it to the banks to take on risky mortgages because their losses would be covered by rising home values—as long as home values continued to rise. Moreover, as long as the borrowers kept up their payments the subprime loans were lucrative. Subprime loans carry higher interest rates to offset the higher risk.
Of course, the answer is more complicated than this would suggest. As we now know, some people at mortgage companies were inclined to steer borrowers to more expensive subprime loans in order to obtain higher fees and bonuses, a practice the new bank law passed in July 2010 now outlaws. In addition, banks sold off their mortgages as bundled securities, folding good and bad loans into a single package, often without the knowledge of the investor who purchased the securities. From the bank’s perspective, the potentially bad subprime loans were now somebody else’s problem, giving them little incentive to apply prudent lending standards to the loans they made. In this environment, they had every incentive simply to make as many loans as possible.
Finally, Fannie and Freddie were under pressure from Congress to open up the housing market to the poor. Conservatives argue that under the circumstances Fannie and Freddie were nearly forced to approve subprime loans. Because Fannie and Freddie were believed by just about everybody to be backed by the federal government (which created them in the first place), no one worried if the loans went bad. The government would ride to the rescue if Fannie and Freddie were in danger of bankruptcy—which is just what happened.
Why is the housing market stagnant?
The housing market is stagnant for two reasons primarily. One is obvious. With rising foreclosures there’s a surplus of stock on the market, driving down prices. Second, banks, having raised their standards, are approving fewer loans. Consequently, not very many people qualify for loans right now.
The game of cause and effect is complex and oftentimes not linear. Many economic variables are compounding to suppress the housing market. However, the big picture looks something like this:
When the bottom dropped out of the economy, many people lost their jobs and lost value in their investments. As a result, there was an epidemic of people defaulting on their mortgages—they simply didn’t have the money to make their payments.
The banks lost a lot of money when people defaulted on their mortgages. Although the banks foreclosed on many homes, these homes had lost much of their value during the crisis. This left the banks stuck with depreciated homes whose resale values are less than the original loan.
The banks, necessarily, can’t afford any more losses right now. Many have all but stopped approving credit.
And without credit, virtually no one is able to purchase a home—which keeps home prices low, perpetuating the problem.
It’s a deadly cycle.
Are Fannie Mae and Freddie Mac private corporations or part of the federal government?
Fannie Mae and Freddie Mac have a complex history with the federal government. Currently, Fannie Mae and Freddie Mac are considered part of the government, and thereby part of the federal budget.
Fannie Mae was established in 1938 as part of the federal government. In 1968 it was privatized under President Lyndon Johnson in a maneuver to reduce on paper the size of the federal budget, which was spilling red ink between the Great Society programs and the Vietnam War. Still, it retained many of the benefits it was accustomed to as a government agency; as a GSE (Government Sponsored Enterprise) it was exempt from taxes and regulation.
In 1970, Freddie Mac was chartered to compete with Fannie Mae. Freddie was also chartered as a GSE.
In 2008, when the housing market completely collapsed, the federal government reabsorbed the twin mortgage giants—along with its $4 trillion dollars in obligations to investors.
What role did corruption among securities rating agencies play in the mortgage crisis?
The credit rating agencies which are responsible for providing an objective market valuation of “the risk posed to investors by bonds, companies and countries” have been exposed as having a conflict of interest.
There are three principle credit rating agencies—Standard and Poors, Fitch Ratings, and Moody’s. According to the New York Times “hundreds of billions of dollars of assets, later shown to be worthless, received high ratings from one of the agencies,” prior to the housing crisis. Many mortgage backed securities were given “AAA” ratings (the highest rating) despite the fact that the securities were built on the wet sand of subprime mortgages.
When the public realized that many mortgage backed securities were actually toxic and that homes were being grossly overvalued, the market began its freefall.
But why did the rating agencies give such high ratings to securities backed by toxic mortgages?
Well, the originator of the security—an investment bank like Goldman Sachs for example—is also the employer of the credit rating agency. As the Times explains, it’s “a bit like a restaurant reviewer being hired by the chef.”
Allegations poured out that the rating agencies had felt pressure to give their rubber-stamp of approval to the securities of large investment banks for fear of losing business. “In April 2010, in testimony before a Senate panel, four former officials of Moody's and Standard & Poor's said that competitive pressures and conflicts of interest were allowed to undermine accurate, fair and unbiased ratings of complex securities that Wall Street sold to investors.”
Is the era of the 30-year fixed mortgage over?
Until the 1930s the average mortgage extended between three and five years, with a balloon payment due at the end, at which point many people simply took out a new mortgage. With the Great Depression taking ou a new mortgage was often no longer an option, leading to the ruin of millions. The upshot was the invention of the classic 30-year mortgage, which allowed people to spread out the payments with predictability.
Some now are arguing that the 30-year mortgage is itself obsolete. As UCLA law professor Katherine V.W. Stone argued in an op ed in the New York Times, the 30-year mortgage works “well as long as homeowners have stable, long-term jobs that enable them to regularly make their monthly payments. But these days such careers are increasingly scarce. Therefore, any effort to recover from the crisis must include more flexible mortgages that take today’s employment landscape, with its frequent job-hopping and episodic unemployment, into account.”
Her solution?
For starters, the Federal Housing Administration could require that any mortgage it insures allow borrowers who are involuntarily out of work to convert to an interest-only loan for up to two years. Once they got a new job, their loans would switch back. Because the administration insures almost a third of all markets, it has the influence to make this standard practice across the industry.
Such a provision would significantly alleviate the financial burden for the borrower. For example, a conventional mortgage of $100,000 at 6 percent interest requires a monthly payment of $600. But if the borrower lost his job in the first month and the loan became interest-only, the monthly payment would be reduced to $500. The longer the borrower held the loan, the smaller the interest portion of each payment, making the savings even greater for long-term homeowners.
A temporary conversion would lengthen the period of the loan but would not increase the principal. Banks would continue to receive the same amount of interest that they bargained for and would avoid more foreclosures.
Another option is for the federal government to create a “career transition bank” that unemployed borrowers could draw on to meet their payments. To take part, workers and employers would make pretax contributions to personal accounts, and withdrawals would be limited to the amount accumulated. If the money wasn’t used by the time a worker retired, it would be paid out as a lump sum and taxed like pensions or Social Security.
