"What effect has the subprime market had on the real estate industry? Many worry that rising mortgage defaults and lender failures could impact America's overall banking system, forcing declines in the stock market and causing the housing market to face yet another downturn.
So, just what is a subprime loan? They are mortgages given to people with credit scores of 620 or below on a credit scale of 350-850, as a result of a poor credit history of paying debts late or not at all. Subprime borrowers are seen as a higher risk, and their loans typically carry interest rates that are at least two percent higher than those borrowers with better credit. Subprime lenders base their rates and fees on the same factors as prime lenders. The lower the credit score and the smaller the down payment, the higher the interest rate. For example, a good, credit-worthy borrower could obtain a mortgage at six percent interest, while the same mortgage would cost a subprime borrower at least eight percent or more. Also, the entire structure of rates and fees is higher as subprime lenders cover the greater risk and higher costs of subprime lending. Many of these subprime mortgages contain pre-payment penalty fees as well.
According to Experian, a credit reporting bureau, about 20 percent of U.S. consumers have credit scores of 620 or below, and of that group, 13 percent have mortgages. Many of these borrowers have adjustable rate mortgages, or ARMs. An ARM starts out with an interest rate that is lower than a comparable rate on a fixed rate mortgage. After an initial introductory period (usually two to three years for subprime borrowers), the interest rate goes up, which can result in payments that increase by hundreds of dollars each month. Some borrowers have the intent of rebuilding their credit history during that two-year period, with a plan to refinance during the initial fixed period. However, because the overall real estate market has turned, borrowers can't refinance because they don't have enough equity. They also can't sell, because the house is worth less than they initially paid for it. The only option is to try to bring in more income, miss payments or go into foreclosure.
The Wall Street Journal recently reported that nearly 1.2 million mortgage foreclosure filings were reported last year, a 42 percent rise from 2005, at a rate of one in every 92 U.S. households. About 80 percent of subprime mortgages are ARMs. Others include products such as "piggy back" loans that require no down payment, "interest-only" loans and "no doc" loans that let borrowers state their incomes without supporting documentation. All of the above accounted for 47 percent of total loans issued last year. In 2000, less than two percent of subprime loans were issued. Borrowers have never been more leveraged. Loan-to-value ratios, the loan amount as a percent of the property value, have grown to 86.5 percent last year from 78 percent in 2005.
What caused lenders to offer the numerous amounts of exotic loans? Home values were soaring, and lenders raced to offer easy credit to new homebuyers. According to a study by the Federal Reserve Bank of Chicago, homeownership has grown to 69 percent from 65 percent over the past decade.
Anxious first-time homebuyers, those with less than sterling credit, budgets strained by massive credit card debt, bankruptcies and minorities were the typical profile that many subprime lenders attracted, and they have typically been the face of foreclosure. That is no longer true, however, because of the myriad of financing options available. Many people bought the bigger house, the million dollar homes with the tennis courts, stables or golf course. People across all income brackets are facing financial hardship. The explosion of subprime loans made to mostly poorer borrowers is now reaching higher ground.
According to the Mortgage Bankers Association, Americans already face foreclosure at a record pace. Lenders started foreclosure actions against more than one in every 200 U.S. mortgage borrowers in the last quarter of 2006. About 2.2 million foreclosures due to bad mortgage loans may cost U.S. homeowners $164 billion, mostly from lost home equity, according to the Center for Responsible Lending. In addition, in the last three months, the percentage of foreclosures for U.S. homes valued at more than $750,000 has climbed to 2.5 percent, the highest since early 2005. The overall rate of foreclosures also is on pace to increase by a third this year.
Firms that specialized in subprime loans now face large losses or even bankruptcy, as well as some of the financial institutions that lent to those in the subprime market. Big banks are not, in most cases, subprime lenders themselves, but many provide what are know as "warehouse lines" to mortgage companies which draw money from these revolving lines of credit to temporarily fund new loans until they can sell them on the secondary market. The mortgages themselves are collateral, and if they become hard to sell or fall into default, banks fear they will be stuck with collecting on bad collateral. According to MarketWatch, many of the big banks like Merrill Lynch and J.P. Morgan are putting the squeeze on mortgage lenders by reducing or totally eliminating warehouse lines. Several companies, including Mortgage Lenders Network, USA, Ownit Mortgage and ResMae Mortgage Corp, have already filed for bankruptcy protection after having their warehouse lines cut.
Federal Reserve Board Chairman Ben Bernanke stated the damage from the subprime market has been largely contained, and he felt the economy was strong enough to "weather this storm." However, Congress is considering regulations to tighten lending standards, and lawmakers have criticized the Fed and other regulators in recent weeks for allowing too many borrowers to get mortgages they couldn't afford to repay. Freddie Mac also announced it was cracking down on underwriting standards for those loans it purchases.
So what does it mean for the housing market? If all the subprime loans currently in default were to go all the way to foreclosure, it would still be a small part of the overall mortgage market. However, with lending standards now being tightened, fewer borrowers will qualify for loans. The 100 percent stated program is no longer available with several subprime lenders. Countrywide Home Loans sales manager Angie Nunnelley stated, "If you currently have a contract right now with a subprime lender, make sure to keep a close eye on it; it may not be there when you are looking to close. In the end, there will only be four subprime lenders standing in the market."
The effect has changed the marketplace and will continue to do so. With the increased inventory of homes currently on the market, it could magnify the general housing downturn we are now experiencing.
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