subprime crisis

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What is Subprime Crisis? How to solve the subprime crisis?

November 27, 2007

The current Subprime crisis is not really a crisis due to over lending of banks, but situation created due to sub prime lending. Banks don’t have enough money to lend money. We will start with subprime lending.

What is sub prime lending?

The term “subprime” refers to the credit status of the borrower (being less than ideal), not the interest rate on the loan itself. “sub prime” is any loan that does not meet “prime” guidelines. If your mid fico score is below 620 and you have any mortgage rates within 12 months or recent BK/foreclosure, you are considered “sub prime”.

Subprime lending, also called B-paper, near-prime, or second chance lending, is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. The phrase also refers to paper taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and certain types of self-employed individuals. Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, poor credit history, and adverse financial situations usually associated with subprime applicants. A subprime loan is offered at a rate higher than A-paper loans due to the increased risk. (wikipedia ).

What about lending rates?

To avoid the initial hit of higher mortgage payments, most subprime borrowers take out adjustable-rate mortgages (or ARMs) that give them a lower initial interest rate. But with potential annual adjustments of 2% or more per year, these loans can end up charging much more. So a $500,000 loan at a 4% interest rate for 30 years equates to a payment of about $2,400 a month. But the same loan at 10% for 27 years (after the adjustable period ends) equates to a payment of $4,470. A 6-percentage-point increase in the rate caused slightly more than an 85% increase in the payment.

The 2/28 ARM
A very common mortgage in the subprime market, which we have never seen outside of that market, is the 2/28 ARM. This is an adjustable rate mortgage on which the rate is fixed for 2 years, and then reset to equal the value of a rate index at that time, plus a margin. Because the margins are high, the rate on most 2/28s will often rise sharply at the 2-year mark, even if market rates do not change during the period.

For example, the rate is 8% for 2 years but the index is currently 4% and the margin is 6%. If the index remains at 4% after 2 years, the loan rate will jump to 10%.

Some borrowers with poor credit scores take a 2/28 at a high rate and plan to rebuild their credit during the 2-year period. Their plan is to refinance at a better rate at that time. The major threat to such a plan is a prepayment penalty that runs past two years, which some do; and a lender who fails to report their payment history to the credit reporting agencies. Borrowers should be on their guard against both.

Who opt subprime lending?

Individuals who have experienced severe financial problems are usually labeled as higher 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 these events were unforeseen and cause a major setback in finances. As a result, late payments, charge-offs, repossessions and even foreclosures may result.

Due to these previous credit problems, these individuals may also be precluded from obtaining any type of loan for an automobile. To meet this demand, lenders have seen that a tiered pricing arrangement, one which allows these individuals to pay a higher interest rate, may allow loans which otherwise may not occur.

From a servicing standpoint, these loans have higher collection defaults and experience higher repossessions and charge offs. Lenders use the higher interest rate to offset these anticipated higher costs.

Provided a consumer will enter into this arrangement with the understanding that they are higher risk, and must make diligent efforts to pay, these loans do indeed serve those who would otherwise be undeserved. The consumer must purchase an automobile which is well within their means, and carries a payment well within their budget.

How the subprime crisis started?

The subprime lending is 9% in 1996 but in 2004 it is 21%. Due to securitization, investor appetite for mortgage-backed securities (MBS), and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others. In addition to considering higher-risk borrowers, lenders have offered increasingly high risk loan options and incentives to them.

Homeowners had been using the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending. Between 1997 and 2006, American home prices increased by 124%.Easy credit combined with the assumption that housing prices would continue to appreciate also encouraged many subprime borrowers to obtain ARM they could not afford after the initial incentive period. With housing prices now depreciating moderately in many parts of the U.S., refinancing has become difficult, leaving homeowners with higher payments than anticipated.

Beginning in late 2006, the U.S. subprime mortgage industry entered what many observers have begun to refer to as a meltdown. A steep rise in the rate of subprime mortgage foreclosures has caused more than 100 subprime mortgage lenders to fail or file for bankruptcy, most prominently New Century Financial Corporation, previously the USA’s second biggest subprime lender.The failure of these companies has caused prices in the $6.5 trillion mortgage backed securities market to collapse, threatening broader impacts on the U.S. housing market and economy as a whole.

However, the crisis has had far-reaching consequences across the world. Sub-prime debts were repackaged by banks and trading houses into attractive-looking investment vehicles and securities that were snapped up by banks, traders and hedge funds on the US, European and Asian markets. Thus when the crisis hit the subprime mortgage industry, those who bought into the market suddenly found their investments near-valueless. With market paranoia setting in, banks reined in their lending to each other and to business, leading to rising interest rates and difficulty in maintaining credit lines. As a result, ordinary, run-of-the-mill and healthy businesses across the world with no direct connection whatsoever to US sub-prime suddenly started facing difficulties or even folding due to the banks’ unwillingness to budge on credit lines.

As a result

Right now there is “liquidity crisis” on wall street. Basically, because so many sub prime loans are in default, Wall Street investors are no longer supplying money to market which lenders use to lend out over and over again. They make money by originating a loan and selling it to someone else who pays the lender a premium based on future revenue. If lenders cannot “sell” these loans they cannot generate new business. Since guidelines are now so tight, many of these “subprime” borrowers will not be able to refinance their loan. They took short term adjustable loans (2-3yr fixed) which are now adjusting to much higher rates. They can’t afford the new payment and they can’t refi either due to no equity or poor credit.

In the UK, some commentators have predicted that the UK housing market will in fact be largely unaffected by the US subprime crisis, and have classed it as a localized phenomenon.However, in September 2007 Northern Rock, the UK’s fifth largest mortgage provider, had to seek emergency funding from the Bank of England, the UK’s central bank as a result of problems in international credit markets attributed to the sub-prime lending crisis.

What about solution?

Loan modification, pumping money into market may slow down the crisis.

• Establish rescue funds for borrowers facing short-term problems caused by illness, layoffs or other one-time events.
• Establish a bond fund to pay for switching borrowers out of unaffordable ARMs.
• Refinance loans for victims of predatory lending. This would involve working with Fannie Mae, the quasi-governmental corporation.

Changing loan terms is a mess, borrowerand lender must accept to the terms, lenders may be unwilling to change terms but Fed interference will work out. But lender will accept to change in terms to avoid foreclosures.

Pumping money into markets, reducing bank reserves may temporarily weaken the crisis, but these this is two fold operation, pumping money will increase inflation which will results in increase in subprime lending, and reducing bank reserves to small extent is better but as whole destabilize the whole financial system.

Here are some guidelines to prevent that from happening to you:

* Never respond favorably to a solicitation without first checking other options. If you deal with only one loan provider, your prospects are better if you make your selection by throwing a dart at the yellow pages than by accepting a solicitation.

* Check your eligibility for mainstream financing with mainstream lenders. The easiest way to do that is on-line. Some sites that I like for this purpose are Eloan.com, Amerisave.com, and NationalMortgageAlliance.com. These are all Upfront Mortgage Lenders.

* If you can’t qualify with any of them, your best bet is an Upfront Mortgage Broker. They may charge sub-prime applicants a little more because they require more time. You will know what they charge, however, and you will know that you are getting the wholesale price posted by the lender, which means you won’t be exploited.