Financial Markets and Institutions (2-downloads)

Subprime loans are those made to borrowers who do not qualify for loans at the

usual market rate of interest because of a poor credit rating or because the loan is

larger than justified by their income. There can be subprime car loans or credit cards,

but subprime mortgages have been highly publicized recently due to the high default

rates realized when real estate values began dropping in 2006.

Before the securitized market made it easy to bundle and sell mortgages, if you

did not meet the qualifications for one of the major mortgage agencies, you were

unlikely to be able to buy a house. These qualifications were strictly enforced, and

each element was verified to assure compliance. Once it became possible to sell

bundles of loans to other investors, different lending rules emerged. These new rules

gave rise to a new class of mortgage loans known as subprime mortgages.

According to the Mortgage Bankers Association, in 2000 about 70% of all loans

were conventional prime, 20% were FHA, 8% were VA, and only 2% were subprime.

In 2006, 70% were still conventional prime, but now fully 17% were subprime, with

Access the homepage of

MBSCC,

www.ficc.com

, to

get information on this

provider of automated

post-trade comparison,

netting, risk management,

and pool-notification

services to the mortgage-

backed securities market.

G O   O N L I N E

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Chapter 14 The Mortgage Markets

339

the balance being FHA and VA. The FICO score is computed for virtually every bor-

rower. This score is computed by the different credit rating agencies as an index of

credit risk. Though each agency uses a slightly different algorithm, all include pay-

ment history, level of current debt, length of credit history, types of credit held, and

the number of new credit inquiries made as criteria for rating credit worthiness.

The average subprime FICO score was 624 versus 742 for prime mortgage loans.

Several innovative lending practices have led to this increase in lending to less

credit worthy borrowers. First, 2/28 ARMs (sometimes called “teaser” loans) became

popular. These loans freeze the interest rate for 2 years, and then it increases, often

substantially, after that. Piggyback loans, NoDoc, or NINJA (no income no asset loans),

and variations on the graduated payment mortgage, as discussed in the last section,

encouraged borrowers to commit to larger loans than they could realistically handle.

Many saw the increase in mortgage loans to less credit worthy borrowers as

progress. If home ownership is the goal of every American, then relaxed lending stan-

dards allowed more families to reach their goal. The downside was that the com-

petitive nature of the market led mortgage sales people to target less financially

sophisticated borrowers who were less able to properly evaluate their ability to repay

the loans. Additionally, the relaxed lending standards allowed speculators to obtain

loans without investing any equity.

The growth of the subprime mortgage was in part fueled by the creation of the

structured credit products such as the collateralized debt obligation (CDO). These

securities were first introduced in Chapter 8 as providing a source of funds for high

risk investments. A CDO is similar to the CMO discussed above, except that rather

than slicing the pool of securities by maturity as with the CMO, the CDO usually

creates tranches based on risk class. While CDOs can be backed by corporate bonds,

REIT debt, or other assets, mortgage-backed securities are common.

When real estate values were rapidly increasing, borrowers could easily sell their

property if they found themselves unable to make the payments. Once the real estate

market cooled in 2006 and 2007, it became much more difficult to sell property and

many borrowers were forced into default and bankruptcy. As discussed more fully

in Chapter 8, subprime lending was ultimately a leading cause of the financial crisis

of 2007–2008 and led to a global recession.

The Real Estate Bubble

The mortgage market was heavily influenced by the real estate boom and bust

between the years 2000 and 2008. Between 2000 and 2005 home prices increased

an average of 8% per year. They increased 17% in 2005 alone. The run-up in prices

was cause by two factors. The first was the increase in subprime loans discussed pre-

viously. With more people now qualifying for loans, there was increased demand. Note

that by 2004 subprime lending made up 17% of all new loans. This meant that over

a very short period many new buyers were now qualified to purchase homes. While

home construction increased, it could not keep pace with demand.

Real estate speculators were a second driver of the price bubble. People of all

walks of life started noticing that quick and apparently easy money was to be made

by buying real estate for the purpose of resale. The ability to obtain zero down loans

allowed them to buy property easily and with little committed capital. They could

then resell the property at a higher price. Many development projects were sold

out before they were even started. The buyers were often speculators with no inten-

tion of occupying the property. Condominiums were especially popular since they did

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Part 5 Financial Markets

not require much upkeep by the owner until the next sale could be arranged. At

times, speculators were selling to other speculators as the demand drove up prices.

As with most speculative bubbles, at some point the process ends. Default rates on

the subprime mortgages increased and the extent of speculation started to make the

news. Those left owning properties bought at the height of the market suffered losses,

including lending institutions and investors in the mortgage-backed securities.

In the aftermath of a mortgage-fueled financial meltdown, lending policies have

largely returned to selecting capable borrowers. One indication of this is the decline

in global CDO issuance. It peaked at $520 billion in 2006. By 2008 it had fallen to 

$62.9 billion. In 2009 it was $4.2 billion.

The securitized mortgage was initially hailed as a method for reducing the risk

to lenders by allowing them to sell off a portion of their loan portfolio. The lender

could continue making loans without having to retain the risk. Unfortunately, this led

to increased moral hazard. By separating the lender from the risk, riskier loans were

issued than had the securitized mortgage channel not existed. Individual firm risk

may have been reduced, but systemic risk greatly increased.

S U M M A R Y

1. Mortgages are long-term loans secured by real estate.

Both individuals and businesses obtain mortgage

loans to finance real estate purchases.

2. Mortgage interest rates are relatively low due to com-

petition among various institutions that want to make

mortgage loans. In addition to keeping interest rates

low, the competition has resulted in a variety of terms

and options for mortgage loans. For example, bor-

rowers may choose to obtain a 30-year fixed-rate loan

or an adjustable-rate loan that has its interest rate

tied to the Treasury bill rate.

3. Several features of mortgage loans are designed to

reduce the likelihood that the borrower will default.

For example, a down payment is usually required so

that the borrower will suffer a loss if the lender repos-

sesses the property. Most lenders also require that the

borrower purchase private mortgage insurance unless

the loan-to-value ratio drops below 80%.

4. A variety of mortgages are available to meet the needs

of most borrowers. The graduated-payment mortgage

has low initial payments that increase over time. The

growing-equity mortgage has increasing payments

that cause the loan to be paid off in a shorter period

than a level-payment loan. Shared-appreciation loans

were used when interest rates and inflation were high.

The lender shared in the increase in the real estate’s

value in exchange for lower interest rates.

5. Securitized mortgages have been growing in popu-

larity in recent years as institutional investors look for

attractive investment opportunities. Securitized mort-

gages are securities collateralized by a pool of mort-

gages. The payments on the pool are passed through

to the investors. Ginnie Mae, Freddie Mac, and private

banks issue pass-through securities. Securitized mort-

gage securities separate the lending risk from the

lender and lead to increasing risky loans.

6. Subprime loans increased in volume from being a neg-

ligible portion of the mortgage loan volume in the

1990s to 17% by 2006. Zero-down loans along with

underqualified borrows led speculative growth in

home prices and a subsequent collapse when default

rates and lack of real demand became public.

K E Y   T E R M S

amortized, p. 324

balloon loan, p. 324

collateralized mortgage obligation

(CMO), p. 338

conventional mortgages, p. 330

discount points, p. 325

down payment, p. 328

FICO scores, p. 329

insured mortgages, p. 330

lien, p. 327

mortgage, p. 324

mortgage-backed security, p. 336

mortgage pass-through, p. 336

private mortgage insurance (PMI),