Subprime Mortgages

Please read the following information to get a better understanding of the role subprime mortgages played in the financial crisis that began in 2008.

History of Mortgages in the United States

In 1930, the typical mortgage loan was a five-year balloon: The borrower paid interest only for 5 years when the entire mortgage came due. The borrower either had to obtain a new loan or pay off the existing loan. During the depression many homes went into foreclosure.

In response to these problems, policy makers pressed for the 30-year fixed-rate mortgage, promoted by the Federal Housing Administration (FHA) and the Federal National Mortgage Association (FNMA), which was created in 1938.

Fannie Mae (Federal National Mortgage Association) government agency at first was created in 1938. It became a private company in 1968 with government guaranteeing its liabilities. Along with Freddie Mac (Federal Home Loan Mortgage Corporation), founded in 1970, they were tasked to provide a secondary mortgage market. Fannie and Freddie could borrow at lower rates and 1992 law expected them to: “facilitate the financing of affordable housing for low- and moderate-income families…, while maintaining a strong financial condition and a reasonable economic return”.

Institutions in the primary mortgage market pressed Fannie to ease credit requirements on the mortgages it was willing to purchase, enabling them to make loans to subprime borrowers at interest rates higher than conventional loans.

In 1999, the NYT reported that with this move into subprime “Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.”

By 2003 Freddie and Fannie held half of all mortgage debt.

 

Policies that encouraged home ownership

– the mortgage interest deduction

– the capital gains tax exclusion

– federal programs that guarantee some liabilities of mortgage lenders (deposits of savings loans, debt and securities of Freddie Mac and Fannie Mae).

 

Decline in underwriting standards

The share of loans for non-occupant owners (speculators) rose from 5 % in the early 1990s to 15% in 2005 and 2006.  “Teaser” rate mortgages increased. These new loans reduced or eliminated the automatic amortization of principal. Loans with down payments of 3%, or even zero became common.

Borrowers were allowed to take out “refinance” loans for 100% of the appraised value of their homes. Borrowers did not have to document their incomes, assets, and employment.

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