09 Apr How the Subprime Scam Works
I have written a few articles about the crash and burn of the subprime lending market, but why am I so gleeful about the suffering of lenders, such as the recently-bankrupt New Century Financial Group? After all, the subprime lenders were heralded by our presidential administrations, both Republican and Democratic, as the broker of the middle-class American Dream. In reality, these lenders are breaking the American Dream for the middle class.
The subprime scam goes like this: Subprime lenders offer “teaser” interest rates that jump significantly after two years or so, known as a “reset.” Additionally, many loans allow for the payment of interest only and terms of up to 50 years. The idea is to suck the borrower in with a low monthly payment. These loans usually have high closing costs and a large pre-payment penalty. So, when the loan “resets” after a couple of years, the monthly payment will skyrocket, as much as 50%, forcing the borrower to refinance. However, the borrower rarely has the cash to pay the prepayment penalties or the closing costs. No worries, however. The mortgage company happily rolls these fees and penalties into the new adjustable rate mortgage with the “teaser” interest rate that resets in two years. Ultimately, these loans are designed to require the borrower to refinance every couple of years, handing over home equity to the bank.
At first, the new loan programs boosted home ownership to an all-time high, but the entire industry relied on ever-increasing home values. Much like a Ponzi scheme, as soon as the bottom fell out of the housing market, home equity disappeared altogether. This means that these subprime lenders are no longer willing to roll the penalties and fees into a new mortgage. Without the ability to pay thousands of dollars out of pocket, most homeowners are realizing that they have bitten off more than they can chew. These homeowners cannot sell their homes in this housing market, and they cannot make the payments on their bloated mortgages. This “payment shock” is the reason that 60% of all foreclosures are subprime loans, even though they only account for 12.5% of all mortgages, and at least $300 billion in subprime adjustable-rate mortgages will reset this year to higher interest rates.
I recently had a bankruptcy consultation with a 14-year underwriter for the subprime mortgage industry who is sure that she will be out of a job by the end of summer. Like so many others, she was not even interested in keeping her house because her mortgage payments were unmanageable. She told me that, right around the new millennium, lenders “lost their minds.””They completely forgot about the risk side of the equation. They were only interested big commissions,” she recalled.
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