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Subprime Mortgage Crisis

Subprime Mortgage Crisis. Subprime Mortgage Amounts. In 2002, subprime mortgage originations totaled about $200 billion or 7% of the mortgage market. Three years later these originations on these loans grew to over $600 billion or 20% of the market.

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Subprime Mortgage Crisis

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  1. Subprime Mortgage Crisis

  2. Subprime Mortgage Amounts • In 2002, subprime mortgage originations totaled about $200 billion or 7% of the mortgage market. • Three years later these originations on these loans grew to over $600 billion or 20% of the market. • Subprime mortgages generated the highest fees to the predatory lenders.

  3. Subprime Mortgage Characteristics • Adjustable rate mortgages (ARMs) are loans whose interest rates adjust up or down with changes in the Fed Funds rate. • Typically subprime loans were a hybrid 2/28 or 3/27 instrument.

  4. Subprime Teaser Rates • The mortgage rate is fixed for the first two years or three years and then switches to an adjustable rate for the remaining life of the mortgage. • One-third of ARMs taken out between 2004 and 2006 began with "teaser" rates below 4%.

  5. Historically Low Interest Rates • US Federal Reserve lowers Federal Funds Rate 11 times, from 6.5% (May 2000) to 1.75% (December 2001). • The Fed Funds rate bottomed out in 2004 at 1%. • This created an easy-credit environment that fueled the growth of subprime mortgages.

  6. Higher Interest Rates • Subprime loans have interest rates 3% to 5% points higher than prime mortgages. • These mortgages also have higher points and fees, and when these are factored in, the average subprime loan often has double digit interest rates that are 4% to 6% points higher than prime mortgage of similar terms.

  7. Subprime Mortgage Holders Hit Twice • The Fed Funds rate went from 1% in June of 2004 to 5.25% in June of 2006. • The variable portion of the mortgage would kick in after the fixed two or three year period, causing payments to dramatically increase leading to increased defaults.

  8. Refinancing Troubles • When 2/28 and 3/27 mortgage teaser rates ended, borrowers had a reason to refinance before their interest rates jumped. • However, about 80% of subprime mortgages had prepayment penalties, where only 2% of prime loans did

  9. Ability to Pay • The standard test for the ability to make payments is the mortgage payments, taxes, and insurance should be no more than 30% of gross income • With subprime mortgages, this number approached 60%.

  10. Delinquency Rates and House Prices • Delinquency rates on subprime adjustable rate mortgages skyrocketed from about 12% in 2007 to about 36% at the end of 2008. • This led to a rapid loss in home values starting in 2007. In 2008, prices fell by 20%. • Housing prices rebounded slightly in 2009, with the $8,000 first-time home buyers tax credit. • Prices started to fall again when the credit expired.

  11. Securitization • Many subprime loans were securitized (bundled and sold as an investment). • Securitization allows for credit risk to be transferred from banks to investors. • The financial crisis took place because banks did not follow the securitization business model and became investors in Mortgage Backed Securities.

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