The "Sub-Prime" Mortgage Crunch in the U.S.

Factual Questions
1

My understanding:

  • Interest rates were at an all-time low.
  • People borrowed up to their maximum credit limit, based on salary, etc.
  • Interest rates went up.
  • People suddenly found that they could not afford their mortgage payments.
  • Houses went up for sale and no buyers were available (foreclosure).
  • Banks lost a tonne of money since these mortgages were written off.

Did the raise of interest rates by a mere few percentile points really cause this? 'Cause if my mortgage went up by $100 or $200 a month I’m sure we’d cope somehow. And besides, aren’t you able to reap tax benefits in the U.S. based upon your mortgage interest?

So, how did all of this happen?

2

What really cause the problem were “teaser rates”. For the first couple of years of the mortgage the rates were low, but then they’d get bumped up heavily after those first couple of years. The borrowers were assured that before the teaser rate period expired they could refinance their mortgage to a low interest rate. But then the bubble burst and consequently low interest rate mortgages weren’t available when those people tried to refinance. So they were stuck with huge interest payments that they could never hope to afford.

3

What Rysto describes is one aspect of the problem. Another part is the huge number of absurdly stupid loans written during the bubble period. (Sub-prime refers to poor credit scores of the borrowers, not interest rates.) Because real estate values were appreciating so quickly, banks approved borrowers with shaky credit and unverified income for ridiculous loans, usually with high interest rates and huge default risks. Wouldn’t you know it, it turns out loans with huge default risks have a high chance of defaulting!

4

And the lenders then went and sold the mortgages as AAA securities, so they’re not even the ones eating the huge losses.

5

'Splain please.

6

Well, part of the problem was that many people got into no-down payment adjustable rate mortgages that had prepayment penalties if they refinanced before a certain time period had passed. The interest rates on these ARMs were usually quite low, but the amount to which they could jump up at the end of the term was potentially pretty substantial. At the end of the time when the borrower could refi without a penalty, things had changed quite a bit and the borrower could no longer qualify for a more standard fixed rate loan–other foreclosures had dropped the value of their houses lower than their sales price, for example or the original loan was 100% and interest only so no principal had been paid, interesting stuff like that. I have talked to people whose mortgages had gone up by 1400.00/month in the past six months–on top of an already healthy monthly payment, with more jumps pretty much certain in the future.

Let’s make up a totally hypothetical case with absolutely rectally derived numbers, shall we?

Buyer buys house, no down payment, buys house for say 300K. Payment is oh, 1500/month but it’s all interest. Creative financing avoids PMI which protects lender in case of default–but it’s cool because houses always appreciate, right?

Buyer gets past prepayment penalty time, wants to refi to something more reasonable. Lender says sorry, we’ve lost a whole buncha money in the last little while on loans like yours and you’ll have to come up with 10%–who has 30K just laying around?

Let’s just say for S&Gs that borrower scrumps up 30K so it’s a go–but oops! Foreclosures in neighborhood have reduced value of house to 250K! Uh oh! Borrower now has to come up with the extra 50K as well as the downpayment because he HAS to borrow enough to service the original loan, but the house ain’t worth that anymore. Lender will only loan against 90% of the new value of 250K. Borrower says no can do, decides to wait. After all, payment hasn’t changed, right?

More time passes, values are not going up, only down due to many other people who got their great ARM deals before our borrower did defaulting. House is worth less but borrower’s still paying 1500/month to service the original loan, still interest only. ARM term ends. Interest rate jumps 2, 3, 5, however many points. Borrower is now paying say 2500/month to service original loan but now house is only worth say 225K. Borrower will still have to come up with the 75K difference + 10% of appraised value to get out of the bad 2500/month deal.

Borrower says fuckit and goes into foreclosure. Borrower will probably not be able to buy another house for years, if ever, so the pool of available home buyers is smaller but there are lots of houses available to buy. Bank now owns 225K value house they loaned 300K on and short sells it for 200K to anyone who’ll take it off their hands. That 200K now is a valid comparable sale to drive down the appraised value of other houses in the neighborhood. Or maybe it doesn’t short sell at all, but just hangs around getting yuckier, or is sold to someone who rents to crazy meth addicts who burn it down in a chemical explosion. What happens to the neighborhood values then?

Lender only collected X months payments at 1500-2500/month, but the property dropped like 100K in value–they did not make much money off it at all, and there are other costs associated with maintaining and selling bank owned houses–maintenance, appraiser fees, broker fees, etc. and no income once the borrower gives up and forecloses. Bank loses money, is even less willing to lend remaining money to others who want to buy a house. Bank was expecting to make back the original 300K with maybe another 3x purchase price in interest–didn’t get it. Can’t carry the 300K + interest income in future as an asset. Lower assets mean less leverage in future dealings, bad for bank. Bank unwilling to lend out lowered assets without pretty damned good ironclad assurances it’s going to get it all back.

Vicious circle ensues.

It’s too bad that the market adjustment is going to happen–it’s necessary on the macrocosmic level but it doesn’t make it less painful on the microcosmic level. Everybody gets fucked–lower assessed values mean less in property taxes to improve communities already reeling from the glut of foreclosures, and neighborhoods are made less desirable by ugly, rotting, empty houses all over the place. A neighborhood of 90%+ owner occupied homes becomes the next Tobacco Road rental slum, driving long term residents out to other areas. Neighborhood declines until house prices rising in general make gentrification a viable enterprise–but it would have been nice not to have the intervening ten years of slumhood in the first place, to my mind.

There’s nothing simple about assigning blame for the mess, and there will be nothing simple or easy about the resolution. It will be painful, it will be messy and many people are going to be hurt–even those who’ve never owned a house will nevertheless be affected by budget crunches for schools, public transportation, road maintenance, library availability and just general liveability of the community.

It sucks here in Portland, and we’re one of the least affected by the subprime bubble burst, I can’t imagine how bad it’s going to get in the really heavily affected areas.

7

** SmartAleq**

I’ve never read it so succinctly. Bravo to you. I’m genuinely impressed.

So, can anyone tell me why we haven’t reached the same level of concern in Canada?

8

Previous threads in GQ:

Can someone explain what the deal is with the “mortgage crisis” (USA)?

Mortgage credit crisis - clarify in laymen’s terms

The subprime debacle and mortgage insurance

9

Hey, super, thanks. I’ve got some reading to do…

10

Thanks–I’ll leave it to others who better understand the nasty financial chicanery involved in marketing the bundled subprime crap loans as AAA investment opportunities to explain that end of it–I just know the seamy underbelly bits “on the ground,” as it were!

You guys are probably okay for the same reason Portland is–not as many lenders or borrowers desperate enough to make a deal that they’ll gamble ridiculously on assumed appreciation of real estate. Around here the fixed 30 year mortgage is the norm, (when we get really crazy it’s more likely to be for a 40 or 50 year fixed term) and while we have historically enjoyed a ridiculously fast appreciating real estate market we have some checks and balances in place, such as the urban growth boundary in Portland city limits which has been adopted by many other Oregon communities. Development is limited within the UGB and developers are encouraged to infill by subdividing lots and increasing density, thereby avoiding creating the sprawling suburbs so favored in many other housing markets. Both in and outside the UGBs most counties have strict limits on the size of develpments and builders are required to foot the bill for the infrastructure their houses require–in many other communities developers move in, plop down hundreds or thousands of crappy houses but it’s up to the counties to improve sewer and road improvements outside the development, which usually lags way behind the developments because the new houses aren’t producing tax revenue for a period of perhaps years to offset their usage of community resources. Compare that model to what happened with the house across the street from me–the county says sure, you can divide that lot but you have to pave the entire street in order to get approval. The buyer decided that wasn’t a good deal, so I still have my preferred unpaved street and I don’t have a multiple unit across the street. I’m pleased it turned out this way!

Vancouver WA is one of those cities that allowed a buttload of unrestricted develoment, and so did Clackamas county (located to the south and east of downtown Portland.) Now that home prices are falling there are a lot of builders who have shitloads of houses they can’t sell at the high prices the rest of the development paid. So the people who bought high are pissed because there are houses nearby that are either selling at a discount or that aren’t selling at all. I went out on an appraisal for a house they were trying to sell at 950K and it had a “for rent” sign in the window! People who dropped close to a million on a house sure as shit don’t want renters next door. The people who are in established neighborhoods nearby are affected too, because why buy somebody’s ten year old house when you can buy a brand new one for less a few blocks away? So just like that, the established homeowner has lost a shitload of equity, and if they’ve been improving the property they’ve essentially lost that money too. If you can hang in there and don’t have to move or refi you’re okay, aside from the downturn your neighborhood can and often does take–but at least you aren’t homeless!

While Vancouver and Clackamas counties are taking a nasty value hit, Portland real estate values actually rose by 3.9% last year and are expected to stay static this year. This is due in large measure to those liveability measures that the city has taken, measures which can be unpopular at the time they’re enacted but which are a real godsend when times get tough. Vancouver and Clackamas relied on Portland’s rising house prices to subsidize their new growth, figuring that people would flock to the affordable housing they were building in abundance, and for a while it worked. Now that there’s a glut of inventory most people are electing to buy in Portland whenever possible because it’s a great city with excellent infrastructure where home values aren’t plummeting like a paralyzed falcon–making values in the outlying areas drop further and faster than ever.

People forget that real estate is a gamble–it’s a gamble you can live in but it’s nonetheless never a sure thing!

11

Well, a mortgage is an asset to the bank. You pay them interest on it. What the bank can do is sell your mortgage to somebody else. The new owner gets the interest payments(but also the risk of default), while the bank gets cash right now in exchange for it. AAA is just a measure of the risk – AAA means that the risk of default is very low.

So basically what was happening was that unscrupulous lenders were making their terrible loans but them selling them to somebody else. The buyer believed that they were buying loans with a very low risk of default, which was a total crock. So the original lender had every incentive to make bad loans, because they weren’t facing the actual risk of default.

One of the things that’s happened in the wake of the meltdown is that not only did large investment houses suddenly discover that they owned some of these terrible loans, the ways in which they were sold made it very difficult to figure out how many of these bad loans they actually own.

It’s all a huge mess, and I’m of the opinion that it really boils down to people trusting others too much and getting taken advantage of.

12

Missed the edit window:

The same bad loans simply weren’t being made in Canada. I’m of the opinion was that one thing that really helped was a sane interest rate policy from the Bank of Canada. I think that the Federal Reserve held interest rates too low for too long, which meant that there it was too easy to get a loan in the US.

To be honest, I thought that it was obvious back in 2003 that the US was in for a rough ride. The combination of high indebtedness of US consumers with the low interest rates at the time made it inevitable that the US was going to have to go through a rough transition when conditions dictated that interest rates go up.

This subprime mess has just massively exacerbated the problem.

13

Check out this interactive graphic and news story from the BBC posted last November.

14

This is the problem in a nutshell. I’m quoting it here mostly so I can find this thread again if someone asks me the same questions.

Note that the unscrupulous mortgage brokers* were responding to demand on both sides of the market: buyers who wanted to get a home and have it triple in value overnight, and lenders who wanted to buy a bundle of loans that they could sell along at a tidy profit. The buyers wanted to keep up with (their perceptions of) their neighbors, and the banks had to keep up with the other banks, or risk shareholders fleeing. The mortgage brokers were only too happy to help everyone involved, because they got a commission up-front, regardless of whether the borrower is able to continue paying.

My $0.02: if you sell a debt instrument along to another agency, and it goes delinquent within the first five (ten?) years, you should be liable for at least the value of your commission (plus interest) to cover the gap. If you sell an uninsured debt instrument, you should be required to pay to insure it before passing it on.

15

Two reasons.

  1. Canadian banks have not issued mortgages that require interest-only payments.

  2. Buying a house with no down payment has only been available in Canada for the past year or so.

16

Sub-prime borrowers got loans when they shouldn’t have. Mortgage companies disregarded standard debt-to-income ratios and credit scores.

It’s almost that simple.

17

For a good example of the same, read here, from the Boston Globe. Out-and-out fraud was common, it seems.

18

[Disclaimer: I’m a lawyer who represents banks in foreclosures, something I’ve mentioned a couple times on the Dope]

I’d agree with this sentiment, especially the first part. I’m amazed at the lack of sophistication of many of the people who respond to a foreclosure lawsuit (I say that sincerely, and am not being flippant). These people clearly didn’t understand the details of a mortgage, and brokers and banks were happy to collect commissions getting them to sign up for loans that were out of their range (if I can offer one caveat, it is to NEVER sign a loan whose terms are not what you were promised; don’t expect the bank to go back and change the terms after you’ve signed! And be sure to give a hearty “fuck you” to all the greedy people at the closing table who just want you to close so they can get their cut of the deal).

Because, as has been said, those lenders then packaged and sold the loans on the secondary market (most of the Plaintiff’s in foreclosure lawsuits are banks acting as trustee for “asset backed securities”), there was little incentive to make sure that the loan was sustainable.

I’d say this willingness to qualify people for more then they could afford (one borrower indicated that the reason he couldn’t make his mortgage payment was because his job stopped giving him overtime; if overtime is what you need to pay your bills, you are definitely in over your head) has had a greater effect than adjustable rates on mortgages. While it’s true that many mortgages are adjustable, the defaults I see are occuring before the rates change. These people simply couldn’t afford the loans they were being given.

Another huge factor in defaults (at least here in Florida) has been property taxes and insurance rates. While Florida limits tax increases on homesteaded property, that property is re-appraised by the tax collector whenever it is sold. So, people ended up with tax bills much bigger then what the previous owner had paid, something many people didn’t properly consider. Similarly, a rash of hurricanes in recent years has sent home insurance rates skyrocketing, causing huge increases in the monthly payments that many borrowers have had to pay.

19

If it really were that simple, all the big banks could just declare their exposure and we’d all be on our merry way, if maybe a little poorer. The issue at the heart of the credit crunch is that, due to everything being wrapped up in complex structured products, no one was able to say quickly how much money they stood to lose. That’s what caused all the markets to gum up.

20

I wrote a little about the lending and securitization process of these mortgage loans in GD, so if you’ll permit me to quote myself:

Just one addendum to Rysto’s post - they don’t sell individual loans. They sell groups of loans with certain profiles.