CORPORATE POWER: Subprime Crisis - How it all Started

Image by tomsaint11 via Flickr

Subprime Crisis - How it All Started by Jack Sternberg

It All Started In The Early 2000's.

Let's take a walk down memory lane. The economy was healthy and interest rates were low. As a result, consumers felt like spending their money, and this caused real estate values to rise all across the country. And rise they did. In some markets, houses literally tripled in value between 2000 and 2005. That's a 200% gain in just five years. Everyone thought home prices would continue to climb and many jumped on the real estate bandwagon.

Since house and condo values were on the rise, lenders loosened their standards and started crafting mortgages for poor-credit customers. The lenders did this because they felt borrowers would be less likely to default with escalating values, i.e., borrowers could take money out of their homes when they ran into trouble and, thus, repay the loans.

With the loosening of standards, many more buyers came into the market. In 2004, home ownership rates soared to a record 69%. This, in turn, caused housing prices to rise even more, sometimes in a spectacular fashion with double-digit growth occurring in some areas. With this boom in growth, real estate speculators entered the market with a vengeance and created even more demand.

This began a vicious cycle. The more demand there was, the more lenders felt they had to get "creative" with their financing in order to tap into the poor-credit segment of consumers. Again, times were so good, lenders wanted to get a piece of every deal possible.

That "Creativity" Mainly Took The Form of Adjustable Rate Mortgages (ARMs) and Variations On That Form of Loan

ARMs are loans with interest rates that fluctuate up and down. In typical cases, the initial rate is fixed for a period of two or three years.

ARMs do have benefits, of course. Starter rates are lower than those offered by traditional, fixed-rate mortgages. These lower rates mean lower monthly payments. Lower payments make it easy to buy a home and qualify for a larger loan.

However, traditionally, ARMs had been limited to high-income borrowers, who wanted flexibility with their investments but had the capital to repay these loans. In other words, these were low-risk loans for lenders. They could be sure they'd be repaid.

ARMs are a different story with borrowers who had shaky credit histories, and lenders should have known better. Instead, their "creativity" came back to bite them in a big way. Let's look at two examples of the dangerous variations on ARMs to make this point clear.

Interest-only Loans

One variation is the interest only loan. During an introductory period, the borrower pays only the interest on the loan and nothing on the principle balance. Quite a bit of money can be saved during the initial years of the loan (five or more years). The problem comes when it's time to start paying on the principle. "Sticker shock" arrives in the form of much higher payments. For disciplined savers, this is no problem. However, most people don't fall into this category and aren't prepared for the down the line leap in monthly payments.

Payment-option Loans

The other variation is the payment-option loan. With this form of ARM loan, borrowers choose how much they pay each month. They can pay enough to cover the interest plus the principal, the interest only, or even less than the interest. If the borrower chooses to pay less than the interest, that unpaid interest is then added on to the principal. The result is that the borrower ends up owing more than the amount of the original loan.

To make matters worse, many of these subprime loans included burdensome terms, such as onerous penalties for paying the loan off early. This stipulation made it extremely costly to re-finance into a better loan.

Another risk was low requirements for documentation resulting in so called "liar loans." Borrowers could come in with very little proof that they could actually afford the loans. According to First American Loan Performance, liar loans accounted for approximately 58% of all loans in 2006.

In Short, Lenders Were Selling The Riskiest Of Loans To The Riskiest of Buyers

A great number of these ARMs were "hybrid" adjustable loans called "2/28" and "3/27" loans. These loans get their names from the way the loans are reset. For example, in a typical 2/28 loan, it has a fixed interest rate for the first two years. After that, it resets every six months based on an interest rate benchmark.

Once the housing market declined, reset payments rose dramatically-in many cases at least 30%. In some markets, those payments actually doubled. Many homeowners couldn't stand the shock of those increases, and the result was a sharp rise in delinquency and foreclosure rates for ARMs.

Intentionally or unintentionally, ARMs ended up targeted at financially vulnerable buyers. These buyers were fine as long as home prices continued to appreciate. Unfortunately, the opposite happened. First, housing prices flattened, and then they declined. The result has been that many home owners have been unable to refinance their mortgages.

If ARMs had remained a small percentage of the overall mortgage market, they might not have had that great an impact. But, the opposite happened; the percentage grew exponentially from 2001 to 2006, and the rest, as they say, is history.

I've been investing in real estate since I was 20 years old and as a result, became a multi-millionaire before my 25 birthday. I've enjoyed a successful investing career for 30 years now. Part of my success has to do with being able to recognize trends - both good and bad. I saw this subprime crisis coming and I made the necessary adjustments to my own investing methods. I see another challenge headed our way called "The Uniform Closing Instructions" that are about to affect all real estate investors.

Claim a copy of my free report, "The Uniform Closing Instructions Exposed: Critical Factors You Need to Know In A Dramatically Changing Real Estate Investing Environment" at http://www.uniformclosinginstructions.com, so you can be well prepared.

I believe the information in this report is critical to the success of investors across the country, so make sure to download your free copy now while it's still available.

Article Source: http://EzineArticles.com/?expert=Jack_Sternberg
http://EzineArticles.com/?Subprime-Crisis---How-it-All-Started&id=1968416