The Subprime Mortgage Meltdown – Overview And What We Learned

The third and fourth quarters of 2007 saw the end game of one of the most unbelievable runups on the housing market that the United States (and to be honest) the world had ever seen; mortgages were going into foreclosure, foreclosures were doubling from year end to year end, and several dozen mortgage lenders declared bankruptcy within a two week span.

The financial trades have called this the Subprime Meltdown, and with good reason--it bears a strong resemblance to a nuclear reactor going critical and melting down. It's caused repercussions throughout the global credit markets, and is causing doom and gloom among the financial set. However, its root causes, like everything in finance, go back a bit further.

With the stock bubble bursting in 1999, and the country sliding into a recession, the 9/11 attacks caused widespread market panics; in response to the 9/11 attacks, the Federal Reserve started cutting interest rates. The rationale for this is that by trimming interest rates, you stimulate spending rather than savings, and can boost the economy to get it out of the doldrums. If you do this for too long, you get inflation.

What this did to the housing market was give the lowest rates on a 30 year fixed mortgage in over 40 years. Housing starts soared and housing prices boomed. Millions of people refinanced their homes to take advantage of lower interest rates…and due to regulatory requirements about non-discriminatory lending practices, a lot of credit was extended to people who otherwise wouldn't have qualified for a mortgage.

If you were one of the people who was sensible enough to refinance to a fixed rate mortgage in 2003, pat yourself on the back. You're probably happy to have that 4% mortgage right now. Lots of people refinanced, and even more speculated--they bought second homes or condos as 'investments', because the assessed prices kept going up – and would keep going up for the foreseeable future.

The banking industry thought the same way; there's a type of security, called an ABS or Asset Backed Security that's been in circulation since the Eisenhower administration. In principle, what's done is several loans (with fixed, regular payments) were bundled into one security. Most home loans have very good ratings as investments, because banks and mortgage lenders are very picky about who they lend money to. On top of that, they tend to be long term assets. By bundling them together, you can get a diversified portfolio with a regular payment schedule.

This is all well and good so long as mortgage lenders are being careful about who they're writing loans out to. However, by 2005, there were loans being written to people with no down payment, and in amounts of 25% over the listed value of the house. Unfortunately, due to careful ginning up of the packages of asset backed securities, most of these collateralized debt packages weren't AAA assets, the way they'd been marketed. Short form--a lot of investors made a bunch of unwise gambles.

All of these loans and complex financial instruments are built on the idea that foreclosure rates are more or less constant and predictable. Unfortunately, with the surge in mortgage writing, there was also a surge in strange (and downright predatory) mortgage loans made. The big culprit is the Adjustable Rate Mortgage or ARM. These are usually initiated with a teaser rate that's nothing but interest; after a given period of time, the mortgage rate goes up to something fixed on the Federal Reserve rate.

Well, most of those pigeons came home to roost in late 2006, and entire flocks of mortgages with teaser rates had their teaser rates expire in 2007. Most home owners went from 'I can make the payment if I save' to 'My home payment is twice my monthly income' as the rates jumped from 3% to 9 or 10% - which usually doubles or triples the home payment every month.

This caused a rash of foreclosures; suddenly a lot of those ABSs were worth a lot less money, and banks started writing down loans (which is financial speak for 'We aren't getting paid...')

It's a near perfect storm of opaque banking products and an interest rate yo-yo... and we're going to be dealing with the repercussions for the next two or three years.

If you are facing foreclosure, have multiple mortgages on your property, or are several payments behind on your mortgage, you need help fast. Vivid Properties is a group of real estate investors that specializes in buying houses from people like you. You'll receive a fair price for your property, and a simple, no-hassle closing with no costs to you.

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