The recent economic troubles seem to be blamed on the subprime mortgage market. Just over a year ago the subprime mortgage industry began to feel the effects of a looming crisis, and now it continues to spread across different areas of the economy. To understand the financial lessons from the economic slow down you need to understand why it happened. Why did this start and how will it affect you in the long run?
To understand how this really began you need to understand how the mortgage market works. First a subprime mortgage is a mortgage lent to someone who would not normally qualify. This could be due to income, poor credit history or both. As a safeguard these loans usually have a higher interest rate. In addition many of these loans were made as adjustable rate mortgages—which means that the rates would adjust up over time and increase the monthly payments.
The subprime mortgage loans have a greater risk of default and so banks usually limit the percentage that they have on the books. However with the dropping interest rates of the last few years many more people who wouldn’t normally qualify for a mortgage took advantage of the lower interest rates and got mortgages. Many of these people stretched themselves to the limit, assuming that they would be able to refinance when their interest rates adjusted up. However the housing boom ended and many did not build as much equity as they were hoping to, and did not qualify to refinance their mortgages. They found they could no longer make payments and began defaulting on the loans.
It is also important to understand the secondary mortgage market. The secondary mortgage market is the market where banks sell mortgages to other banks. They will package groups of mortgages together and sell the groups to other banks. In theory this spreads the risk between multiple banks, and protects everyone if the housing market were to burst in one area. For example a typical bank would hold mortgages in several different locations: California, New York, London and Georgia. Chances are that mortgages spread over such a wide area.
Fannie Mae and Freddie Mac are key in helping the secondary mortgage market to function. They purchase the loans from the original banks, so that the banks will have liquidity to make new loans, and then sell them to other banks, often investment banks. The secondary mortgage market experienced trouble when investment firms, other countries and banks stopped wanting to buy these mortgages. They feared that they were no longer valuable because of the recent foreclosures and defaults on all the subprime mortgages.