Sub Prime Mortgages

For many, many years people with poor credit, non-traditional income or both could not get a mortgage. The market responded about 10 or 12 years ago with sub prime and Alt-A mortgages, which to one degree or another addressed the needs of these borrwers.
In the last three years not only were these mortgages very lax in their underwriting standards they were also relatively inexpensive, which was seen at the time as very beneficial for consumers. While great for the borrowers, many sub prime lenders who could not sell the mortgage backed securities because of their low rate of return went out of business, sending waves of panic across the financial markets. Here in Connecticut the most notable victim of this was Mortgage Lenders Network who by most accounts went broke giving sub prime and Alt-A loans at better than A loan prices.
The problem with sub prime and Alt-A loans is that just because you can get one of these mortgages doesn’t necessarily mean you can pay it. Agency mortgages, i.e. Fannie Mae or Freddie Mac, or government mortgages FHA or VA, require that you have decent credit and that prove your income, then they use mathematical formulae to determine what you can afford. Many of these sub prime or Alt-A mortgages did not require proof of income and lent money to people with marginal credit histories.
For the past ten years or so housing has seen steady if not rapid appreciation. Lenders counted on this appreciation when setting their underwriting guidelines. They calculated that if they lent you $300,000 on $300,000 house and you paid them like a champ for two years or three years before you ran into trouble, they would have recouped their origination costs, and then some, and the house would have developed its own equity in the rising market. Enough equity that you would either sell it yourself to protect your equity or they would foreclose and be made whole in the liquidation of their collateral.
These three factors unsound underwriting guidelines, low rates and a softening housing market have conspired to create the problems that face us today.
A perfect example of these factors is a loan I did three years ago for this young couple who were buying their first home. It wasn’t a starter home by any standard, it was a 3800 square foot newly constructed home with a marble kitchen and 3.5 bathrooms, central air and vacuum, 11 foot ceilings on all three floors including an additional 1900 square feet in the finished walkout basement. The couple worked at one of the major insurers in the area and made about $100,000 a year combined. Why were they looking at houses close to $500,000? Because with their credit they could, on paper any way, afford it with an Alt-A, stated 5/1 interest only adjustable rate mortgage. The borrowed the full amount, $478,000 and had a housing payment slightly more than half of their combined, gross monthly income.
Were these people stupid? Yes and no. I wouldn’t have done it, but they figured that they would buy as much house as they could possibly afford and as that house increased in value they would reap the benefit of that appreciation of the larger asset. The problem is that there has been no appreciation. This couple is about two years from their first adjustment on their mortgage when their rate will go up 2% and they haven’t paid a dime against their principle yet. Both of these borrowers were pretty sharp, college educated and financially astute. In two years they will probably own an asset that while appealing, desirable and functional will not be worth what they paid for it. Unless they have received substantial raises they will not be able to afford the house when their rate adjusts. What do you think they will do?
Now, do you believe these people are in need of some government intervention on their behalf? They are both adults, they knew the risks but felt the rewards and the added benefit of living in a grand home outweighed them. The lender knew the risks too. When two 25 year old borrowers with two years on the job at an insurance company states his or her income high enough to buy a $478,000 home and more importantly pays a higher rate so that they can state and not prove their income, you don’t need to be Warren Buffett to see there is some risk there. Apparently the lender felt the risk was outweighed by the rewards.