A key catalyst in the housing bubble was the growth of the subprime mortgage market. What are subprime mortgages and how do they differ from ‘normal’ ones? Actually, we can differentiate between three categories of mortgages: Prime, Subprime and Alt-A. Prime mortgages are what most people think of as normal mortgages. The are given to borrowers with solid income and decent credit (“prime borrowers”) and the borrowers provide full documentation of income, assets and liabilities. Subprime mortgages are more risky than prime mortgages. Borrowers have weaker credit histories, and no verification of income or assets. Alt-A mortgages fall in between prime and subprime. They are given to borrowers with good credit histories, but who provide lower documentation to support the loan, or who provide less than 20% down payment.1
Subprime mortgages are offered to individuals who would not normally qualify for a mortgage. Often times, individuals were not even required to put any money down. These candidates usually had low income and/or poor credit, making the loans very risky.
Most subprime mortgages were a form of adjustable rate mortgage (ARM). They had a low initial “teaser” interest rate, which would reset after a period determined by the mortgage contract, usually two or three years. While the mortgage payments were affordable during the teaser period, they increased dramatically after reset.
Mortgage brokers reassured potential borrowers that, given the rate of price appreciation of houses, they could easily refinance their mortgages after the teaser rates expired. With higher home values, lenders would be willing to refinance the mortgages at lower rates. This assertion assumed the borrower’s home value would continually increase after the purchase of the home. Thus, loan originators continued to lend and individuals continued to borrow. As a result, subprime mortgages grew to account for more than one fifth of the total mortgage market between 2004 and 2006. A list of the top 25 subprime mortgage lenders is available here. Click on any of the companies listed for detailed information on their subprime lending activities.
Subprime mortgages, by definition, were riskier than prime mortgages. Why would mortgage originators make risky loans like this? In part, they did it because they did not plan to hold on to the mortgages. Rather, the mortgages were packaged together and sold as Collateralized Mortgage Obligations (CMOs), just like the mortgage-backed securities (MBS) issued by Fannie Mae and Freddie Mac. The difference was that unlike Fannie and Freddie whose securities were backed (at least originally)by prime loans, the CMOs were often backed by subprime and alt-A loans.
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- Strictly speaking there is a fourth type, Jumbo mortgages, which are similar to prime mortgages except they are larger amounts than the maximum allowed for FHA or VA loans (“conforming loans”). In our discussion, we will count jumbo loans as part of prime loans. ↩