There has been some speculation – and even some evidence – that subprime mortgage loans are making their way back into the mortgage universe. An article on the respected mortgage website HSH.com seems to confirm this. In The Return of Subprime Lending? HSH projects the return of certain speculative types of mortgage products that were decided culprits in the mortgage meltdown that began 2007.
I’ve been hearing bits and pieces of information indicating that this development has been coming out. This is the first time reading it from a credible source. Not every type of subprime mortgage loan is making its way back, but this is pretty much how subprime lending got started back in the 1990s.
Why subprime mortgage loans are coming back
Since it is a virtual certainty that subprime mortgage loans contributed substantially to the mortgage meltdown, why would the industry even contemplate bringing them back? Answer: for the same reason they brought them out first place – to get more business.The reality of economic life is that anytime an innovation increases business it will always be seen as having its uses. It matters not that it may ultimately be toxic to the big picture, as long as it puts more money in someone’s pockets today, it will be resurrected from the dustbin of history.
The obstacles in the mortgage business remains substantial. Though the market has largely bounced back in many areas, new construction is still running less than 50% of the peak in 2006. Many people who would’ve been able to buy a house in the mid-2000s are still shut out of the market, due to tighter credit regulations and the fact that mortgage lenders in general are now completely risk adverse. Subprime mortgage loans are seen as a remedy to many of these limitations.
What’s more, with mortgage rates rising and the fate of both Fannie Mae and Freddie Mac now in doubt, mortgage lenders and the housing industry are looking to different lending sources.
Subprime won’t look the way it did before – or so we’re told
Among subprime proponents, the consensus is that they won’t look the way they did a few years ago. They’ll have certain safeguards in place to make sure that it doesn’t turn into the mortgage lending free-for-all that existed during the 1990s and early 2000’s. I’m not at all convinced of this claim, but more on that theme in a minute.
Subprime loans relate primarily to credit impaired borrowers. In theory, subprime loans are made available to people with below lender quality credit, but compensated for through higher interest rates. We should fully expect to see a return of mortgages for the credit impaired, but subprime loans aren’t limited to those with credit issues.
Other loan types that became very popular before the meltdown – and are either anticipated to make a comeback, or already heading down that path – include:
Interest only mortgages . You pay interest on the money that you borrow, but your loan contains no provision to pay down your principal. Since the loans are not self amortizing, they typically contain adjustable interest rates. This means that the monthly payment on the mortgage will rise as interest rates do. The low rate you started with may not be the one that you’re paying one or two years into the loan. These loans have already begun making a comeback.
Balloon mortgages . The most common arrangement has you making payments based on a 30 year term at less than the 30 year rate, but requires full payoff of principal or conversion to a traditional 30 year mortgage at the and of a certain fixed rate period. That term can be anywhere from three years to 15 years. These are actually the least risky loans for a borrower, as long as interest rates don’t rise substantially at the end of the initial term.
No income verification (NIV) mortgages. These loans became a mainstay in the mortgage industry just prior to the meltdown. Though they were originally reserved for a very small number of very elite borrowers, over time their use expanded to include typical borrowers. Since the boom that preceded the meltdown was largely paved with NIV mortgages, it’s easy to see why the industry, and particularly the housing sector, wants these loans back
Zero down mortgages. It’s hard to determine which loan type greased the wheels of the last housing boom more, NIV or zero down mortgages. Since traditional mortgage programs require a down payment of anywhere from 3.5% to 20% of the purchase price – and since Americans are notorious for our inability to save money – it’s even easier to see why the housing sector wants these loans back.
Subprime Mortgage Fiasco Part II won’t end any more happily than the first go-round
In the case of each of the above loan types, including those to the credit impaired, the word is that there will be stiff requirements wrapped around each program. For example, the NIV will require a substantial down payment, say 20%, plus stellar credit. A zero down mortgage will require superior credit, a demonstrated high income, and substantial proven assets.
Such restrictions may prevent a repeat of the mortgage meltdown, but I’m not at all convinced. I was in the mortgage business in the 1990s when these programs were being rolled out. The tight restrictions built around them were also in place when the programs started. The problem was that as time went on the restrictions were relaxed.
For example, on the NIV programs, the down payment requirement was originally 25% – 30%. After a few years, it dropped to 20%. And then 10%. And then 5%. Eventually, some lenders concocted programs that combined NIV with zero down mortgages. That’s not a liar loan – it’s a suicide loan – for both the lender and the borrower!
Here’s the problem… Lenders kept pushing the envelope on these speculative mortgage programs based on the results of risk scoring models. For example, when NIV loans required a 25% down payment, the performance on those loans was excellent – after all, who is going to walk away from a house with 25% equity in it?
As a result of that favorable experience, the down payment requirement was lowered to 20%. Same situation – the loans continued to perform well. So the down payment was lowered to 10%. At this point, there is a bubble in the housing market, and prices are rising steadily – fueled at least in part by the preponderance of NIV loans. As long as house prices increase, both the borrower and the lender can always get out of the mortgage profitably.
But the problem with all speculative mortgage programs is that they fail miserably when prices stagnate or decline. That’s exactly what happens when a housing bubble collapses.
“Those who cannot remember the past are condemned to repeat it.” – George Santayana, Spanish novelist
Will that be our fate in Subprime Mortgage Fiasco Part II? Given the human tendency to “rinse and repeat” when it comes to bad judgment, I wouldn’t bet against it.
Why subprime mortgage loans are NOT your friend
Okay, so what is the practical application in regard to subprime mortgage loans? Simply this: subprime mortgage loans are NOT your friend.
Just because subprime loans come back – and even if they come back in force – doesn’t mean that you have to participate in the madness. Don’t underestimate how this will impact your behavior when it comes to the real estate market. When everyone else is drinking the Kool-Aid, you’ll be tempted. And even if you don’t take a subprime loan yourself, you will still suffer the consequences of marketwide participation in them.
As an example, millions of people bought houses using NIV and zero down mortgages. This participation caused house prices to explode, creating a bubble that no one thought would ever end. But when it did, it hurt far more than just the subprime borrowers. If you bought or refinanced your house at or near the price peak, the market collapsed on you, just as it did on all subprime borrowers.
If you start to see subprime mortgage loans make a wholesale comeback, not only should you abstain from them, but you should also become very conservative in your real estate outlook. There ARE bad times to buy a house, and during a bubble is just such a time. Sure, values may rise in the short run. But just as sure as you are reading this article, prices will eventually collapse. When the next bubble begins to develop, resist the urge to buy or to refinance for more than what you paid for the house.
That advice alone will enable you to ride out the next real estate boom/bust cycle in relative comfort.
What do you think about the return of subprime mortgage loans to the housing market?