Why is the “Subprime” Mortgage Market Collapsing?

Anyone who’s read the newspaper, looked at a business magazine or watched the news has heard about the problems in the “subprime” mortgage market. This is the area of the financial product industry (as it’s now called) that makes loans to folks who have some credit problems. Defaults on subprime loans are at an all-time high, with over 14% more than 30 days past due. Subprime mortgage lenders such as ResMae Mortgage, New Century Financial and Accredited Home Lenders have filed for or appear to be headed for bankruptcy, and even the big Wall Street lenders such as Citibank and Goldman Sachs, who funded subprime lenders, are feeling the heat. Congress is looking into passing new legislation restricting subprime loans (about five years too late, in my opinion).

Many theories are circulating about how matters reached this point. As I see it, the nut of the problem is that in subprime lending—indeed, in nearly all mortgage lending these days—no one in the process has an interest in making a loan that the borrower can actually repay. In fact, there are significant incentives in loaning more money than the borrower can afford. Look at who has a finger in this pie:

The mortgage broker only cares about getting the transaction to closing, where he/she gets paid. In fact, the worse the deal to the borrower, in terms of a higher interest rate over what they qualify for (the “yield spread premium”) and a higher loan amount than they can afford, the higher the profit for the broker.

The underwriter is usually a computer program, not an individual, applying a check-off list designed only to make sure that the loan can be sold.

The originating lender only cares about getting the loan closed, selling it immediately, getting its profit out, and turning around and loaning more money to repeat the cycle.

The purchaser of the loan doesn’t care, because the loan is bundled with thousands of other mortgages and securitized. Subprime loans are actually of benefit, because they allow tranches, or groups, to be established with lower risk (by comparison) and lower interest rates. And even if the loan defaults and goes into foreclosure, there usually isn’t much of a loss, if any: most or all of the loan amount are usually recovered from the foreclosure proceeds.

And the servicer doesn’t care, because it gets higher fees when the loan goes into default.

No one in the process really cares that the borrower is able to make the payments over the term of the loan. As a result, we see loans where the monthly payment is more than the gross income of the borrower, loan terms that virtually guarantee a default, etc. And if enough borrowers default, then we have the problem we’re facing today.

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