DavidWaring

As many of you know there is lots of news out about sub prime loans and the issues they are causing for the consumer, the economy, and in the financial markets in general. While I have seen a lot of coverage of recent events with subprime I have not found through my research many good resources for leaning about how exactly this all happened. So in this three lesson series we are going to examine exactly how all this came about by looking at things from the borrowers side of the equation in this lesson, and then the lenders side of the equation in subprime explained lesson 2. Then we are going to tie everything together in the sub prime crisis explained lesson 3 by bringing our newfound understanding of both sides together to understand exactly what caused the problem, what we are experiencing now, and what we are likely to see going forward. As always, we'll strive to make this complex issue simple to understand.

A subprime loan is a loan given to borrowers that are considered more risky, or less likely to be able to make their loan payments, in relation to high quality borrowers because of problems with their credit history. When you go to get a loan you need to get a credit check, and what results from this credit check is something that is known as your FICO score. A FICO score is a number which represents how credit worthy you are considered which is based on factors such as the amount of money that you earn, your record of paying back past debts, and how much debt you currently hold. The higher the score the better your credit is considered, and the more likely you are to get a loan.

In order to understand how these sub prime loans have caused so many problems, we must first understand what happened in the years leading up to the recent problems. In the years leading up to the sub prime crisis interest rates (or the cost of borrowing money) had been at historical lows as the fed had aggressively cut interest rates to avoid going into recession after the tech bubble burst in 2000. While you don’t need to understand all the details of the effects that low interest rates had you do need to understand two things:

1. When interest rates are low in general it causes the economy to expand because businesses and individuals can borrow money easily which causes them to spend more freely and thus increases the growth of the economy.

2. What drives interest rates lower is the fact that there is an increase in the supply of money, meaning that there is more money to go around.

Before the Fed lowered interest rates substantially after the bursting of the NASDAQ bubble in 2000, if you wanted to get a loan for a house you had to have a relatively good credit score. Buyers with a FICO score below 620 (generally considered sub-prime) where in most cases considered too risky to lend to and therefore could not get a loan.

After the fed lowered interest rates to historical lows however there was so much money (also referred to as liquidity) available that financial institutions started offering loans to buyers with FICO score’s below 620. Because these borrowers were considered less likely to be able to pay the loan back than borrowers with higher credit scores, these sub prime borrowers were charged a higher interest rate.

Things initially went very well for the financial institutions that made these loans because in the years that followed interest rates stayed low, the economy continued to grow, and the real estate market continued to expand causing the value of most people’s houses (including the sub-prime borrower’s houses) to go up in value pretty dramatically. This made it relatively easy for these borrowers to make payments on their loans as if they ran into financial trouble they in more cases than not could tap the equity in their home (which came from the increase in the house price) to refinance at more favorable terms or to make their mortgage payment. Because a relatively few of these sub prime borrowers were defaulting on their loans, the financial institutions which held these loans were enjoying the additional profits earned by charging these borrowers a higher interest rate, without many problems.

After the initial success and profitability for those offering sub prime mortgages the practice expanded dramatically and the terms which borrowers were given in order to allow them to obtain loans became all the more creative.

There are now many different types of sub prime loans such as:

Interest Only Mortgages: These loans require the borrower to pay only the interest portion of the loan for the first few years thus keeping the payment relatively low for the first few years before the interest only component expires and the borrower must pay the principle and interest component of the mortgage payment (of course a much higher amount)
Adjustable Rate Mortgages: Unlike traditional mortgages have a fixed interest rate so your payment is the same each month, with an adjustable rate mortgage if interest rates rise (as they have been recently) your monthly mortgage payment goes up as well.
Low Initial Fixed Rate Mortgages: Mortgages that initially have very low fixed rates and then quickly convert to adjustable rate mortgages. .

Because house prices had increased so rapidly in the last few years many of these sub prime borrowers took out loans that they could not afford in the anticipation that, when the mortgage reset to the higher payment, they would be able to refinance at more favorable rates using the increased value of their home and the equity that they now had as a result of that.

So now that we have a background on what was happening on the borrower’s side of the equation the next thing that we will look at is what was happening on the lender side of the equation. Once we have a background there then we will tie everything together in the third and final article so you have a good understanding of all the factors at play here in the sub prime crisis.

As always if you have any questions or comments please feel free to leave them in the comments section below, and have a great day!

Additional Resources That Explain the US Subprime Crisis:

Behind the Scenes of Your Mortgage
A Simple Snapshot of the Subprime Loan Market
Subprime Crisis Sours a US Dream
The Subprime Meltdown - A Simple Explanation
The US sub-prime crisis in graphics
A Simple Slideshow Explanation of the Subprime Crisis

Unregistered

Hi David,

Brilliantly presented explanation of the Subprime Crisis!
Got a question. As far as I understand a mortgage is a method of using property as security of an obligation, which is other words is a guarantee that if the borrower doesn't pay back the money, then runs risk of foreclosure of the mortgage by the bank to recover the debt. Any money received from the sale is applied to the original debt, but in this case I take it that the money received from the sales must have been quite significantly lower than the initial loan after the bubble burst in order to have originated this gigantic worldwide crisis. Do you know how creditors are dealing with the sale of properties held in guarantee?
Is it simply the difference between initial loan and the received sale price that has originated this whole subprime crisis or is it that properties aren't selling and banks are stuck with them?

Thanks,

Anthony

David Waring

Hi Anthony,

Good question.

Yes a mortgage is a secured loan which means that the loan is secured by the the property which will be foreclosed upon by the lending institution if mortgage payments are not made.

This is in contrast to unsecured loans, the best example of which is credit card debt. While if you do not pay your credit card bills the lenders can come after you, they do not have rights to a specific asset and therefore it is much harder for them to recover their losses.

A couple of points to note here to answer the other part of your question.

In the past banks have required a borrower to put down 20% of the value of a house upfront so that the bank is protected if the borrower does not pay. What this means basically is if say they make a loan to someone to buy a $100,000 apt that person puts down $20,000 and the bank lends them the other $80,000. In this case if the borrower does not pay their mortgage payments the bank can come in and foreclose at which point it has a house that is hopefully still worth at least $100,000. This gives them plenty of breathing room to sell the property and get back the full $80,000 they loaned.

In recent years however as liquidity has increased as outlined in my videos, banks have become more aggressive with lending to people who put less than 20% down and in the subprime space in particular were even making loans to people as aggressive as no money upfront. So this obviously gives the bank a lot less breathing room if the property is foreclosed upon to sell that property and recoup their full loan amount. As property prices have been falling in a lot of areas recently and more and more people default the financial institutions that are holding these loans are often times stuck in a situation where they foreclose on a property that is not worth and they cannot sell for enough to get back the full they have loaned.

So yes this is a problem but there is actually a bigger problem than this.

When these loans are packaged up and sold as outlined in the second video in this series on the subprime financial crisis, what the buyers of those mortgage pools are buying is the rights to the future principle and interest payments on all the mortgages in that pool. So if a borrower whose mortgage is in that pool defaults not only does this cause a potential loss because of what I have outlined above but it also causes a potentially much larger loss to the holder of the mortgage pool due to the loss of the future interest income on that asset. As the typical mortgage is 30 years most of the time the amount that a borrower pays in interest on the property they buy over the life of the loan is more than the value of the property when they bought it.

Now when these mortgages are packaged up and sold in these large pools, the sellers of those pools and the buyers of those pools use financial models to try and predict the amount of people who are going to default on their mortgage over the life of all that pool as well as how many are going to prepay their mortgage or pay the mortgage off before the end of the loan which would also result in a loss of the future income on the loan. Once they have estimated this they take that data and this is how they come up with a value for the mortgage pool.

So now that we understand this we can understand the bigger problem here which is that a lot more people are defaulting on their mortgages than the buyers of those mortgage pools were thinking would, so they are now taking huge losses on those pools which are assets to the financial institutions that own them as they have to mark their value down to current market valuations which reflect the increase in defaults.

Hope that explains it a little better. If there are any other questions or comments on the US subprime crisis please feel free to post them below.

Best Regards,
Dave

Unregistered

Sir,

I have started working in a bank recently and frankly, do not know much about the field yet. In you article, you have commented that initially, as the house prices were booming, when the ultimate borrowers (people who bought homes from moneys borrowed) ran into any financial difficulties, they could tap into the (increased) value of their homes in order to get money to repay their loans to their lenders.
My simple question is, what was the way this was happening...I mean, would these borrowers approach their lenders and start negotiating with them? Or, were they approaching other lenders who would then look at the (higher) house prices and lend to them?
I have seen that banks ask borrowers to submit all ownership papers with them....So, can borrowers even get loans from other borrowers, without papers?
How does all this happen? Could you explain by means of an example?

Regards,
Gautam

David Waring

Hi Guatam,

Glad to hear from you.

There are two ways that this could happen:

1. As the value of the house increases then by default so does the equity that the owner holds in the house. As a result the owner of the house (the borrower) can tap into that increased equity through a home equity loan.

So as an example lets say that someone buys a home for $1 Million putting down 20% ($200,000) and borrowing the remaining $800,000 by taking out a mortgage. So at this point the borrower has $200,000 worth of equity in the house.

Next lets say that the value of their home increases over the next two years by 20% to $1.2 Million. Now the homeowner has $400,000 in equity in the house.

Depending on the financial situation of the borrower, many times they can now tap this additional $200,000 in equity by taking out what is known as a home equity loan or line of credit for $200,000 or some portion thereof.

2. They can refinance their mortgage at a more favorable rate. All else being equal now that (using this same example) this house is worth $1.2 Million, assuming everything else remains constant, the borrower should be able to get a more favorable loan. This is because of the increased amount of equity they hold in the house, and therefore the increased quality of the asset that is securing the loan.

Good luck with your new job. Let me know if this does not make sense or if you have any questions.

Best Regards,
Dave

Grissi

Hello.

I really enjoyed these lections. Just what i diddnt know, explained a way could understand. Thanks!

Dong

Hi David,

Building upon your reply to Gautam, does the borrower usually (in real life cases) use the $200,000 gained from the home equity loan to refinance their original loan, or do they renegotiate with the bank to get a more favourable loan? What are the usual options used by the borrower in seeking solutions to their financial problems?

Sorry for the late question, seeing that your last reply is 3 months ago. I just found out about your wonderful article in my quest to understand the subprime crisis. Also, pardon me if my question happens to be common sense in the US as I'm from Asia.

Many thanks in advance.

Best regards,
Dong

David Waring

Hi Dong,

Glad to hear from you.

A home equity loan is money that you pull out of your house to spend on other things such as a home improvement, car, vacation or pretty much whatever you want.

So basically this is separate and in addition to the mortgage that one already has on their house. Instead of pulling the equity that one has built up in their house through out to spend through a home equity loan, a homeowner may instead use their increased equity to refinance their mortgage which simply means replacing their current mortgage with another that has more favorable terms.

Hope that helps. If there are any other questions or comments please feel free to post as always.

Best Regards,
Dave

__________________
My Free Courses: Forex Course - Stock Course - Futures Course - Basics of Trading - Subprime Crisis - Prorealtime Charts

Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

Unregistered

If I fave invested money in a USA bank, will it be risky to leave it there, or should I take it to another country´s bank?

David Waring

Hi,

Glad to hear from you.

In the United States there is something called Federal Deposit Insurance which insures money in a bank account up to $100,000. So with this in mind I personally would not be worried about money in a bank account so long as I did not have over $100,000 in that account. If I did have over $100,000 in an account I would divide that money up among multiple accounts, at multiple banks, just to be on the safe side.

Hope that helps. If there are any other questions or comments on this one please feel free to post as always.

Best Regards,
Dave

__________________
My Free Courses: Forex Course - Stock Course - Futures Course - Basics of Trading - Subprime Crisis - Prorealtime Charts

Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.