Subprime Mortgage Crisis

A subprime mortgage is any loan extended to someone with poor credit that allows them to buy a home in spite of their poor repayment history. In general, anyone with a credit score below 620 qualifies as subprime. These borrowers pay significantly higher rates of interest in order to compensate lenders for the increased risk they represent. When prevailing interest rates on home loans are 5-6%, subprime borrowers routinely pay in excess of 9%.

The problem with subprime mortgages is that when the economy weakens and people can’t afford to pay for their homes, subprime borrowers are the first and most frequent defaulters. It is important to remember that defaulting on a home mortgage is very rare. Historically, the post-Depression era has never witnessed default rates greater than 4%. Current default rates in the subprime market are in the neighborhood of 2%. While not high by historical standards, near the end of a decade-long run-up in real estate prices default rates fell to less than 1% just a few years ago. Lenders like HSBC and New Century Financial made billions of dollars at the height of the boom extending loans to almost anyone who wanted one. Now that the real estate market has weakened, these over-aggressive lenders are losing their shirts. New Century Financial in particular has exacerbated its troubles through Enron-esque accounting gimmicks and is now the subject of an SEC investigation and numerous shareholder lawsuits in connection with its collapsed stock price.

Because of the size of the real estate market, easily measured in trillions of dollars, the current subprime mortgage implosion has cost big lenders an enormous amount of money. However, home mortgages are generally one of the most secure loans that banks can make. Even if the borrower defaults, banks can foreclose on the home and generally collects about 75% of the value of the loan by selling the house. Also, subprime mortgages represent a tiny part of the total mortgage market. When 15% of the mortgage market is subprime and only 2% of these risky loans are defaulting, it is clear that most homeowners and their banks will be just fine.

Many prominent economists have claimed that they see a great risk of spillover from the subprime mortgage market into the economy at large. George Soros’ partner and former Fed chair Alan Greenspan have both indicated that the crisis could spread throughout the economy. Their rationale is that in a weakening economy, people will be particularly harmed by the declining value of their homes. Since the national savings rate is still negative, homeowners have been driving the retail economy by taking out lines of credit on their homes. As poorer people with subprime mortgages lose their homes and drive down the value of everyone’s real estate by flooding the market with houses at fire-sale prices, homeowners are much less capable of borrowing to drive consumer spending.

If things in the subprime mortgage market get worse, some prominent Democrats and Republicans from effected states are already talking about a government bailout along the lines of the S & L bailout. This is a particularly appealing model, not only because the government saved thousands of jobs immediately by buying into the Savings and Loans but also because it ultimately made money on the deal.