The Collapse of the Subprime Market

The Collapse of the Subprime Market

SWilson

April 17, 2008

Table of Contents

Subprime lending……………………………..…………………………1

A Second Chance………………………………………………….2

Predatory Practices………………………………………………..4

Subprime Mortgage Industry Collapse……………………………...5

Lending and Credit Crisis……………….……………………...…5

CDO’s….………………………………………………….….6

Those Most Affected….....................................................................7

Conclusion………………………………………………………………11

Subprime Lending

The expansion of subprime lending can be attributed to many factors: federal legislation preventing state restrictions on allowable rates and loan features, the tax reform act of 1986, increased demand for and availability of consumer debt, and an increase in subprime securitization. In October 2000, the U.S. Department of Housing and Urban Development (HUD) set forth a new rule that increased the affordable housing goals of government sponsored agencies such as Freddie Mac and Fannie Mae. In the rule, HUD identifies the subprime market as a way for Fannie Mae and Freddie Mac to meet their goals, and as an area in which more standardization can be created. A subprime loan is given to individuals who have experienced severe financial problems, are usually labeled as high risk and therefore have greater difficulty obtaining credit, especially for large purchases such as automobiles or real estate. These individuals may have had job loss, previous debt or marital problems, or unexpected medical issues, usually unforeseen and causing major financial setbacks. As a result, late payments, charge-offs, repossessions and even bankruptcy or foreclosures may result. Due to these previous credit problems, these individuals may also be precluded from obtaining any type of conventional loan. The rates and fees for subprime loans are generally higher than prime loans. This is to cover the high cost and associated risk of subprime lending. More often than not, written into the loan agreement are mandatory prepayment penalty clauses. As with prime loans, escrow of taxes and insurance are not required for subprime loans. While the development of the subprime market has made homeownership available to those that otherwise would not qualify, borrowers that may qualify for prime loans are often steered into subprime loans. This type of behavior can sometimes lead to unscrupulous lending practices. For many years, the mortgage industry classified borrowers as either “A” paper or “B” paper. This classification actually did separate lending into credit challenged or not. Prime lending was more reserved for banking which provided short term, revolving construction or equity loans. These loans were usually tied to the prime interest rate plus points. B” paper represents a loan, usually credit challenged, that did not meet investor, Fannie Mae or Freddie Mac’s standard lending guidelines. Due to this, lending institutions began to develop loans to accommodate this sector of home buyers. It was very similar to “second chance financing” heard advertised through auto dealers. As property values had steadily increased, it was believed the equity would provide a built in insurance policy in the case of default.

Second Chance

Subprime lending was once seen as a second chance for borrowers to live the “American Dream” of homeownership. The majority of borrowers were placed on loans called a 2/28 or 3/27, arm loans. The design of the loan program allowed an affordable start rate (still higher than market) for the first two (2/28) or three (3/27) years, and the loan would adjust annually for the remainder