The Truth about the Sub-prime Meltdown

In this article I am going to try and explain in very plain terms what happened and how, with the “subprime meltdown”. In the 1990’s home ownership rates were fairly stagnant. In an effort to extend its business and in response to the federal mandate to open up housing to more Americans, the mortgage industry created loans with looser guidelines for credit and income qualification. Also interest rates were at their lowest in recent history, which made home buying more affordable to more people. Demand for homes began to grow exponentially.

More mortgage products became available. There was a dramatic increase in adjustable rate mortgages such as the “payment choice arm or negative amortization arm loans”. In addition to this there was the advent of computer-automated underwriting which relied more on the credit score of the borrower. No money down programs became much more prevalent and available to borrowers with lower credit scores. Income documentation became less a qualifying factor in determining ability to repay loans. It was boom times baby! In addition to this, many people started to see their home values increase at unprecedented rates because of the high demand. Some communities saw values go up over 35% in a year. Normal home appreciation is usually between 5 and 6% on average nationally.

Because of the unprecedented growth in the capacity of people to get loans, many new loan officers and mortgage companies came into the market. Some of these loan officers were untrained and uninformed about the mortgage business. Some were just crooks looking for the next get rich quick scheme.

Meanwhile on Wall Street, there was a strong appetite for mortgage backed securities as investment vehicles. Home owners may be dimly aware that their mortgage is held by someone other than the bank that lent them the money. Many Wall Street investment houses started making a lot of money from these new mortgage backed securities and were demanding more. The ratings company’s that rate bonds and securities were giving these investments AAA ratings. Lenders barley could keep up with the demand for these “high quality” investments. The common sense lending rules which had for so long governed the lending world were being cast aside. Practically anyone with the desire to own a home could buy. Investors were getting 100% financing to buy investment homes that they could then flip over to another purchaser and because the values were increasing so rapidly, make a few thousand dollars on the flip. Builders were putting up new homes so fast that at one time the Gypsum company worried about running out of the raw resources necessary for manufacturing their products. It was the gold rush all over again. And homes were getting more and more expensive. Left behind was the low to middle income family. That family could not make enough money to afford their first home. And they were being induced into purchasing homes that were in the $500,000 and $600,000.00 range. First time home owners don’t normally buy a half a million dollar house as a starter home. But that’s exactly what was going on in this crazy market. Many new immigrants to this country were also getting in on the home ownership game, both legal and illegal. It’s a fact that the fastest growing segment of the housing market from about 1995 to 2006 was the Hispanic market. And they were primarily buying homes with ZERO down, and ZERO income verification. I know this because I was there and saw it first hand. Many of the loans they were getting were ARMS and negative amortization loans. I know because I was there.

So what happened? I call it the perfect storm. All of a sudden, the lenders started to change the guidelines. Someone started to wake up and realize that what was going on was crazy. Many of these loans were, 1. Fraudulent, 2. High risk and 3. Bad lending practices. I don’t know whom was the first to start to realizing this, but some one was starting to smell the coffee. And it didn’t smell real good. So there was a slow down in the demand for homes. People realized they really couldn’t afford to own a $600,000.00 home while working at a McDonalds, and drive a BMW and make trips to Punta Cana.

As the demand for homes started to subside, people who had negative amortizing loans and adjustable rate mortgage started to see their payments increase. And guess what they couldn’t afford that home any longer. Many of these new borrowers were calling their loan officers who had told them, “Don’t worry, I will refinance you in a year so you wont have to pay the higher payment” or “Don’t pay attention to the 30 year payment, your payment is only $1,600.00 for this $600,000.00 home”. Many realtors were complicit in this marketing as well. Many of them didn’t really care that the buyer was a dishwasher, married to a busboy buying that house. So now that family is busted. The wife and the husband are arguing because they can’t afford to pay the bills anymore. The cousin that moved in with them to help them has decided to leave and get his/her own place now. And since they can’t afford the home anymore they just walk away. They really don’t loose much since they didn’t put money down to purchase it anyway.

This, sadly, is the reality of what has caused this mortgage meltdown. It’s the same story that has caused many to loose their lives, yes I said their lives. Greed! Greed and jealousy are the culprits. They are the demons that possessed the mortgage market and as a result brought about this demise. But is it really demise or is it a return to normalcy? I personally think it’s the latter.

So what happens next? What does normal lending look like? I’ll tell you this; it doesn’t look anything like what you have seen in the recent past. More to come soon.