What's Up with Sub Prime Loans?

Over the past few months---and really over the past year---columnists and financial analysts have been making a wide range of predictions about the consequences of a slowdown in housing on economic growth. There have been a wide range of opinions raised about why home values are declining and what should be the focus of public policy on this issue, put one potential culprit for a decline in housing is getting a disproportionate share of attention: rising defaults among borrowers of subprime loans.

This post is meant to be a primer on the housing decline and the role of subprime loans in what could be a wider economic malaise.

1) What is a subprime loan?

A subprime loan is a loan issued to a borrower with a low credit rating that is unable to qualify for a mortgage from a traditional lender. Subprime mortgages are riskier loans--or else the mainstream lenders wouldn't have had a problem issueing them---to weak borrowers who usually have to borrow the down payment on a home purchase, leaving them with mortgage obligations equal to 100 percent of the purchase price. Obviously, they also bear a higher interest rate to compensate the lender for the greater degree of default risk.

When thinking about whether a subprime loan is a good or bad thing, it's important to realize that the benefit of the subprime market is that it is intended to provide home loans for people with impaired or limited credit histories. These borrowers are lower income individuals and likely have unstable income, savings, or employment, and a high level of debt relative to their income.

2) Why are you hearing about subprime loans now?

A few years ago, defaults in subprime mortgages wouldn't have been a big deal becuase subprime mortgages represented only a small fraction of the total mortgage market. Today subprime mortgages comprise almost one quarter of all mortgage originations. From 1994 to 2005, the subprime home loan market grew from $35 billion to $665 billion. Another fun fact, from 1998 to 2006, the subprime share of total mortgage originations climbed from 10 percent to 23 percent. So let's say that subprimes constitute 20 pecent of the mortgage market. the Center for Responsible Lending predicts that 20 percent of the subprime loans will end in forclosure. So a total of 2.2 million people could lose their homes. If you put about 4 or 5 percent of these homes back on the market within the next few months, there could be a serious effect on home valuations.

Writing in the WSJ on 3/21/07, Andy Laperrier of ISI Group:

"It's no coincidence that the five-fold growth in subprime lending occurred at a time when home prices soared to nose bleed territory." As home prices kept rising, fewer loans went bad because the homeownder could almost always refinance or sell the property at a profit...As the home price boom gained momentum and delinquencies dropped, lenders offered progressively easier and riskier lending terms...According to Credit Suisse, the number of no lor low documentation loans-so-called "liar loans"-has increased to 49 percent last year from 18 percent of purchase loans in 2001. The investment bank also found that borrowers put up less than a 5 percent down payment in 46 percent of all home purchases last year."

2) Why are borrowers of subprime loans defaulting?

One reason is that loans issued in the past few years--of which there were many!---were structured such that the interest rates on the loan were low at first, but rose dramatically after some period of time (maybe after 1 or 2 years depending on the structure of the loan). It could be that more borrowers are now seeing the spike in their ARMs (Adjustable Rate Mortgages).

There is probably more to it than that. Unless one believes that the low income borrowers were completely duped into believing that the loan were carry a low interest rate all the way through. It is true that there are genuine scams going on, otherwise known as predatory lending. But it's more likely than borrowers figured that, if the value of home prices kept rising as they were between 2000 and 2005, they would be able to refinance at a lower interest rate down the road, when they had achieved a degree of equity in the house. Unfortunately for borrowers, the value of homes have been declining, not rising, making it nearly impossible to refinance at a lower interest rate, and possibly leading to defaults.

3) What will the impact of increasing default rates be on the economy?

In a worst case scenario, a wave of anticipated defaults on subprime mortgages and tighter lending standards could combine to drive down home values. That could make homeowners feel a little less wealthy, and lead to a decline in confidence among consumers and then a subsequent decline in spending. But there are a few things that would need to happen for subprimes to infect the rest of the economy in a broad way. As mentioned above, subprimes are only a portion of the home mortgage market. If subprime loans are going bad, but home values in other areas are stable or rising, then one would not expect problems with subprimes to filter there way through the economy. But, if collapses in subprime markets lead to declines in home prices in a broadbased way, than it could be possible that subprime problems will spread through the entire housing industry, then to consumer confidence, and then into other areas of the economy.

Writing in the FT on 3/21/07, Krishna Guta writes:

"Like the market, the Fed sees the main risk to growth coming from housing...But the Fed sees little evidence that this (subprime loans) crisis will have much of an impact on the economy as a whole. Subprime borrowers contribute a relatively small slice of consumer spending and, with delinquency rates up only a fraction, lenders are not seen as likely to draw back from offering credit more broadly."