(...continued from part one) Subprime Mortgages Traditional mortgages have been the norm in the housing market until "creative lending" practices came about in the late 1980's. Instead of the traditional 20% down - 80% loan, mortgage lenders started offering subprime loans at 5-10% down. Borrowers choosing to give less money up front would have to pay for homeowners insurance that would pay the bank in case of default. This type of subprime loan, in turn, made buying a home feasible to people with poor credit scores who would otherwise not be able to afford a home, or qualify for prime lending rates. Then, early in this decade, zero-down mortgages became popular as more lenders offered this type of loan to facilitate higher demand in the housing market. And in 2002, interest-only mortgages came onto the market. As the name suggests, a borrower would pay only interest for the first few years of the mortgage until the payment would reset to a higher amount over the remaining term of the loan. Similarly, adjustable rate mortgages (ARMs) start out with lower interest rates and then reset to higher rates after the introductory period is over. As the bubble in the housing market grew, subprime mortgages only added fuel to the fire, especially between 2004 and 2006, when about 21% of all new mortgages were subprime (wikipedia). By 2006, subprime mortgages totaled $600 billion, or one-fifth of the U.S. home loan market (wikipedia). And, with all this borrowed money inflating home prices, the bubble was about to burst. Pop! What a bubble heavily relies on is the expectation that home prices will rise. Imagine an investor buys a home valued at $250,000 with an interest-only mortgage that he expects to sell in three years when the price rises and before the mortgage resets. Now imagine that instead of the home's price rising, it drops to $200,000. The homeowner now has negative equity on the home and a compounding mortgage debt. The homeowner must now pay an ever increasing mortgage on a home that is losing value. What options does this homeowner have? Very few. If he chooses to sell his home for $200,000, he would still owe $50,000 plus interest to pay off the mortgage. If he chooses to stay in the home, his mortgage payments would reset to a much higher, unaffordable rate. Ultimately, the homeowner would get behind on the mortgage payments and the bank would foreclose the property. By 2007 and into today, foreclosures have skyrocketed. This is causing housing prices to decline rapidly. And, in some areas like Cleveland, Las Vegas, and Los Angeles, foreclosure rates have reached all-time highs (44-4). To make matters worse, foreclosed homes drag down home values in the surrounding community, further compounding the problem. At the same time, many homeowners are trying to sell their homes in order to avoid foreclosure. As a result of all these foreclosures and homes-for-sale, the housing market is flooded with invetory. Therefore, with supply high and demand low, home prices have declined even further, leading the country into a possible recession. Bailouts As the housing market and the overall economy dip into the trough of the crisis, politicians are coming out of the woodwork to propose possible solutions. Bailout and relief plans have been proposed by everyone from Bush and Bernanke to Clinton and McCain. Both discretionary and nondiscretionary fiscal policy, in the form of adjusted interest rates, stimulus rebates, loan-term adjustments, are being employed to stabilize the situation. However, despite the attempts at revival, economists predict the housing market and the overall economy will not begin to appreciate until 2010. Lesson Learned? Among all this turmoil and economic instability, it will be interesting to see how the housing industry responds to the bursting bubble. Although lending standards have already tightened as a result of so many foreclosures, will the necessary steps be taken to ensure risky subprime lending is cleaned up? Will people learn to be more responsible about their borrowing and lending practices? Can future bubbles be prevented? Only time will tell. (written by K. Skowronski)
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