A Primer on Subprime Mortgages

The term “subprime mortgages” has leaped from business pages to the front page headlines. However, not a lot of people understand exactly what it means and how it caused the US economy to fall. What Are Subprime Mortgages? Simply put, mortgages are called subprime because they are below prime status. These are loans given to borrowers who normally wouldn’t be given loans in the first place. They are considered high-risk borrowers because they have questionable credit history, meaning they either can’t prove their source of income or they have taken loans before that they didn’t pay off. The problem began when banks, which had too much cash on hand, began competing with each other to offer loans to the public. They became sloppy and gave loans to everyone who would take them, regardless of their capacity to pay back. As expected, subprime borrowers took the loans. Who wouldn’t want to get the funds to be able to buy a house without any down payment? The loans were used to either buy new homes (hence, the term subprime mortgage) or used to pay off other loans against the increased value of their existing homes. After all, house values were supposed to always go up. The intention was to offer borrowers a way to buy a home while they are looking for a job or while trying to repair their credit history. What Happened to the Subprime Mortgages? To complicate matters, banks sold the mortgages to investment banks, which combined them into a new instrument called collateralized debt obligation or CDO’s. These CDO’s were then sold to home mortgage companies Fannie Mae (Federal National Mortgage Association) or Freddie Mac (Federal Home Loan Corporation), who further sold them to investors, now with the government guarantee. Since the government guarantee provides the assurance that the investment will be paid off, they were sold at low interest rates. This is despite the high risk associated with CDO’s, since the performance of these instruments will depend on whether the subprime borrowers would pay off their mortgages. Mortgage lenders, from global financial institutions like AIG and Citigroup to small local banks, all rely on Freddie Mac and Fannie Mae for available mortgage funds. They all bought CDO’s since Freddie Mac and Fannie Mae own about half of the $12 trillion mortgage market. How Does Subprime Mortgages Affect the Economy? The problem began when subprime borrowers began to default on their loans. It was something that was bound to happen sometime given their poor credit ratings. Repossessions and defaults ripped through the US housing system at a staggering rate. There were so many homes put up for sale with no buyers. Fannie Mae and Freddie Mac had to pay out their investors out of their finances, crippling them, in order to meet their obligations. Similar to the domino effect, the entire industry was affected because nearly all financial institutions had exposure to these toxic debt instruments. It’s hard to believe that the current financial crisis stemmed from the fact that people took out loans they couldn’t afford (and banks gave loans to people who couldn’t afford them), but that is what happened. This is a lesson to everyone, especially the banking system, that loans should be handled correctly. GP