The most recent casualty of the subprime mortgage implosion is the recent bankruptcy of American Home Mortgage Investment Corp., at one time the nation’s 10th largest mortgage lender. American Home joins more than 50 lenders so far this year that have filed for bankruptcy protection.
The vast majority of lenders who have gone belly-up have been the so-called subprime lenders, which lend to folks who do not have an acceptable credit history to qualify for conventional financing. The subprime mortgage market’s demise has been daily news this year and frankly, it should have surprised no one.
The explosive growth of the subprime market over the last several years was borne out by a strong demand for high yielding loans on Wall Street. Folks with impaired credit turned to the subprime market to become homeowners. Obviously, subprime lenders charge higher rates and fees to compensate for the riskier borrowers.
But Wall Street loved it. After all, the loans are secured by real estate.
Why not earn 9 percent on your money instead of 6 percent? I saw the implosion coming long before it actually happened.
Consider the following subprime scenario:
m Subprime borrowers typically have a history of not paying their bills on time, or at all, for whatever reason.
m Subprime mortgage products carry significantly higher rates and fees than conventional mortgages, making affordability more difficult for folks who already have a spotty credit history.
m To exacerbate this obvious problem, most subprime loans carry stiff prepayment penalties, preventing borrowers who may have cleaned up their credit from refinancing to better terms.
Come on now. This is a fool’s recipe.
But American Home Mortgage was not specifically a subprime lender. One former AHM employee told me that the company emphasized Alt-A mortgage paper, which carries slightly higher rates than conventional loans.
These products cater to folks whose financial situation is better than subprime candidates, but doesn’t quite meet conventional standards.He said AHM also focuses on the so-called Option ARMs, which allow very low payments, resulting in negative amortization.
Here’s the question. If AHM isn’t a subprime lender, what caused its implosion? It appears that AHM’s funding sources were cut off after it was determined that market values of the homes that secured the mortgage dropped.
As I have always emphasized, having a variety of mortgage products to choose from is a good thing for the consumer, but it also must come with understanding. The following hypothetical scenario could explain what scared off AHM’s investors.
AHM makes an Option ARM loan to folks who have good credit but put only 5 percent down.The borrowers chose an Option ARM because they could buy a bigger house with a lower monthly payment.
Skyrocketing home values left them with no choice.
Suddenly the housing boom ebbs and their property value drops a bit.At the same time, interest rates rise so the borrowers rely on the lowest payment option, resulting in negative amortization.The loan balance is rising each month because the borrowers’ monthly payment doesn’t cover the interest charged.
This, coupled with a drop in property value, suddenly puts these folks “upside down,” meaning the mortgage balance exceeds the property value.
This is not a doomsday scenario. Most homeowners have good credit, lots of equity in their home and have no trouble making their mortgage payments. But the scenario described here illustrates a possible outcome when folks choose to purchase a property that they cannot intrinsically afford.
It is up to the borrower to be financially responsible, and it is up to all of us in the mortgage business to advise our clients wisely.
Henry Savage is President of PMC Mortgage in Alexandria. Reach him by
e-mail at firstname.lastname@example.org.