Conventional wisdom (or market spin) was that the risk of default from subprime would not spill over into Alt-A and Prime loans. This argument was made because these two categories have historically had low default rates. Of course, this argument ignored the “liar loans” taken out by those with higher credit scores, the unmanageable debt-to-income ratios, and payment resets for interest-only and Option ARM loans which were also given to the Alt-A and prime crowd. Historically, this group had not defaulted because they have not been widely exposed to these loan types.
An adjustable rate mortgage resets to a different (usually higher) interest rate or payment schedule at a time specified in the loan agreement. The increase in payment may be caused by an increasing interest rate or it may be caused by a recast of the loan to a fully-amortized payment schedule. In either case, the monthly payment will rise.
If a borrower is unable to make the new payment because wages did not increase or perhaps the payment increase was simply too large, the borrower will need to refinance to a new loan with an affordable payment structure. If at the time of refinancing the borrower is not eligible for available loan programs because the borrower or the property no longer meets the prevailing loan standards, the borrower may have no choice but to default on the existing loan and go through foreclosure on the property. In short, if borrowers cannot make the new payment or refinance, they will lose their homes. This is how many borrowers lost their homes during the housing bubble.
The worst of the exotic loans was the negative amortization loan. The loan balance can grow each month as the deferred interest is added to the loan balance. This capitalized interest is recognized as income on the books of mortgage holders. Generally Accepted Accounting Principles (GAAP) allow this, but the amount of income is supposed to be reduced to reflect the likelihood of actually receiving this money. Since the loan program was new, and default rates were low due to the bubble rally, the reported income was very high making these loans even more appealing to investors.
From the investors’ perspective, they were buying high-interest loans with great income potential and low default rates. From the borrowers’ perspective, they were obtaining a loan at a very low interest rate, a perception rooted in a basic misunderstanding of the loan terms, and a very low payment which allowed them to finance large sums to purchase homes at inflated prices. This dissonance between the investors who purchased these loans and the borrowers who signed up for them did not become apparent until these loans began to reset to higher rates and recast to higher payments.
It was not the borrowers; it was the loans. Exotic loans were given to people of all credit backgrounds. Subprime borrowers where the first to show distress, but the Alt-A and prime borrowers had the same problems and experienced the same outcome.
The only question about the subprime containment theory is whether or not FED Chairman Ben Bernanke and others who were espousing it were embarrassingly ignorant or knowingly duplicitous. Given their positions in government, it is most likely they were lying to the public to buy themselves time while they figured out what to do about the problem.
Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
Learn more and get FREE eBooks at: http://www.thegreathousingbubble.com/
Read the author’s daily dispatches at The Irvine Housing Blog: http://www.irvinehousingblog.com/
[tags]housing, real estate, buying real estate, housing bubble, real estate bubble, house for sale[/tags]
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