The Escalating Crisis of Foreclosures and Subprime Mortgages

Overview of Subprime Mortgages and ARMs

Subprime mortgages, designed for borrowers with lower credit scores, have significantly contributed to the increase in home loan defaults. Initially, these loans were a small fraction of the market, with only 8% of total originations in 2003. However, by 2005 and 2006, they surged to represent 20% of all new mortgages (Federal Reserve).

Key Characteristics of Subprime Mortgages:

• High Initial Approval Rates: Attracted borrowers with lower interest rates in the initial years.
• Adjustable Rates: Interest rates on these loans reset to higher rates after the initial teaser period, significantly increasing the borrower's monthly payment.
• High Foreclosure Rates: More than half of all foreclosures by the end of 2006 involved subprime loans, highlighting the risk associated with these mortgages.

Adjustable Rate Mortgages (ARMs) are another product that has seen widespread use and subsequent scrutiny. These loans offer initial lower rates that reset at higher rates after a predetermined period. The most common types were the 2/28 and 3/27 ARMs, which constituted 60% of all subprime mortgages issued in 2006.

Economic Impact and Regional Trends

The foreclosure crisis has not only affected low-income areas but also wealthier neighborhoods. For instance, in Sacramento, CA, delinquencies on subprime loans of 60 days or more reached 14.1% in December 2006 (Wall Street Journal). The cost of foreclosure per property ranges between $40,000 to $50,000, with lenders reporting losses up to 50 cents on the dollar.

Understanding ARM Terms and Risks:

• Initial Lower Rates: For example, a 2/28 ARM offers lower rates for the first two years.
• Balloon Payments: Some ARMs require a large payment of the remaining balance after a set period, often leading to refinancing challenges.
• Documentation and Interest Rates: Loans with reduced documentation typically carry higher interest rates.
• Prepayment Penalties: Early refinancing or selling can incur significant penalties.
• Exclusion of Taxes and Insurance: Some ARMs do not include these in monthly payments, requiring lump sum payments from the borrower.

Visualizing the Impact: A Comparative Analysis

Consider a $200,000 loan comparison between a fixed 30-year rate at 7.5% and a 2/28 ARM starting at 7% which then adjusts to higher rates. The fixed-rate mortgage remains constant at $1,598 per month, whereas the ARM payment increases from $1,531 in the first two years to $2,370 by the fifth year, assuming a 2% rate increase in year five.

Conclusion and Future Outlook

The subprime mortgage and ARM issues have created a significant financial strain on many American families. The rolling up and securitization of these mortgages have exacerbated the problem, leading to a broader economic impact, including the credit crunch that former Federal Reserve Chairman Ben Bernanke addressed through policy adjustments. Moving forward, it is crucial for both lenders and borrowers to fully understand the risks associated with these financial products to prevent a recurrence of such a crisis.