Subprime Underwriting Standards

Source: Joint Economic Committee October Subprime Report

During the housing boom, home prices skyrocketed. It became increasingly difficult for the average homebuyer (and the average speculator) to qualify for conventional loans. To meet demand, mortgage lenders began to issue more ARM loans and more interest only loans, which allow borrowers to qualify based on an initially low interest rate or payment.

The problem with this is there is no consideration given to the borrower's ability to repay the loan in the future. When interest rates reset and the interest only period ends, the borrower is forced to either deal with the reset payment, refinance to a more conventional loan, or sell.

Knowing that they were taking a gamble, lenders increasingly relied on prepayment penalties and asset values to provide earnings. The borrower's ability to pay suddenly became a moot point.

Technically, there are supposed to be laws against this in most states, but enforcement is varied and weak. Mortgage companies also have the ability to get around these laws with low-documentation and no-documentation (liars) loans, which can make a mortgage look affordable for almost anyone.

Another common practice involves selling subprime loans to the secondary market. Most lenders hold a very small percentage of the subprime loans they originate; the majority of the loans are securitized.

Source: Joint Economic Committee October Subprime Report

After 2001, the percentage of securitized subprime loans increased significantly and reached a peak of more than 81 percent in 2005. This gave mortgage lenders an even bigger incentive to ignore borrower interest and underwrite high-yielding subprime loans.

Who is Responsible?

According to Inside Mortgage Finance, the majority of subprime mortgages originate through mortgage brokers. Broker share of the entire mortgage market did not change much between 2003 and 2006, but the broker share of subprime loans increased during this period. By 2006, mortgage brokers originated an estimated 63.3% of all subprime loans.

But this doesn't mean brokers are 100 percent to blame. Brokers are sales professionals--middlemen. Their job is to make the sale and maximize income; getting a borrower an inexpensive mortgage ranks rather low on the priority list. In fact, it is typically more beneficial to the broker to make sure the borrower pays more.

Lenders sometimes offer brokers incentives (yield-spread premiums) to sell loans with interest rates above and beyond the minimum acceptable rate of the mortgage loan. Brokers can also earn extra fees for originating a loan with a pre-payment penalty.

There is absolutely no incentive to originate a loan the borrower can afford. If a borrower defaults, the broker does not suffer any adverse effects.

It is important to note that none of this is illegal. According to most state laws, mortgage brokers are not required to act in the best interest of their clients. In other words, if brokers want to put their own interests before a borrower's, they have a legal right to do so.

Which brings us to the bottom line: it is ultimately the borrower's responsibility to learn how to recognize and avoid a predatory situation.