SUBPRIME LOANS

For 70 years, the mortgage market was, give or take, on autopilot. Loan guidelines rarely changed, as government and conventional loans all had to meet their respective rules. In the late 1990s, a couple of loan types began to emerge, and they weren’t government or conventional. They were subprime and alternative. Subprime loans were so labeled because the credit grades of the borrowers were ‘‘less than prime.’’ Alternative loans were sometimes called ‘‘Alternative A,’’ or simply ‘‘Alt A’’ because even though the credit grade of the applicants was good, the loans didn’t fit the conventional or government box.

It was an alternative to conventional or government loans. Subprime lenders have been around for 20 or so years and required that the borrowers have more money down for their purchase, usually a minimum of 20 percent or more. Subprime loans, then, were designed for those who had enough money for a down payment but, for whatever reason, ran through some hard times. They were laid off from work or otherwis lost their main source of income. Perhaps there was a death in the family— such an event can wreak havoc on anyone’s financial profile. When losing a loved one, it can be hard to concentrate on making the car payment on the first of the month. Subprime loans were designed as a temporary solution to fix a mortgage problem. Their rates were much higher than what could be found for those with good credit, but were a temporary fix—a financial Band-Aid. The trick with subprime loans was to get someone into a house with a mortgage and begin to repair their credit with timely mortgage payments and meeting all other credit obligations each month, every month. After a couple of years’ worth of good credit behavior, the subprime borrower could then apply for a refinance mortgage into a traditional conventional or government loan.

This typically worked because the borrowers had to pony up some major cash at the closing table, and the subprime loan provided a path to credit repair. Subprime loans weren’t intended to be sued to those who had no intention of paying anyone back on time. Alternative loans, or alt A loans, also had their intended market— those who couldn’t or didn’t care to divulge their income or asset information. Often times, this meant someone who was obviously very well-to-do, had good credit, and could perhaps have a very complicated financial portfolio. I recall a client here in Austin who was wealthy, owned several corporations and investments, and hence some complicated tax returns. Alt A loans will accept ‘‘stated’’ applications, meaning the income or asset information isn’t documented by tax returns or bank statements but instead relies on sufficient down payment and excellent credit. People with excellent credit didn’t get excellent credit by accident: they earned it over a period of time. My client’s tax returns for all his businesses, and this wasn’t even counting his assets, were literally eight inches thick. Alt A loans don’t require all the typical documentation.

In lieu of that documentation, e loans accept a sizable down payment and also a slightly higher interest rate. If a conventional jumbo loan could be found for 7.00 percent, then an alt A loan might be available for 7.25 percent. This is such a small increase in rate in exchange for fewer headaches. In each case of subprime or alt A loans, lenders made sure there was a pool of buyers for those loans. They guaranteed significant rates of return, while at the same time churning out loans day after day and opening up credit markets that weren’t previously available.

But that presented a slight problem. If a lender came up with a mortgage loan that addressed a segment of the consumer market, what if the market soon became saturated and there was no longer any consumer to offer that loan to? Subprime and alt A lenders would regroup, identify another market segment they could offer a new loan program to, and then pitch it to investors, who would buy those loans. After all, so far, the buyers of those loans were making tons of money. In the early 000s, subprime and alt A loans began to take charge of the mortgage lending environment in the United States. In fact, in many estimates, these loans managed to capture nearly 40 percent of all loans made in the country. Think about that for a second. Since the early 1900s, FHA, VA, Fannie, and Freddie, were the mortgage rule of law. Suddenly, and for a very short period, subprime and alt A loans collectively owned more of the mortgage market than Fannie, Freddie, VA, or FHA did individually. This also came about when the federal government was making a major push for home ownership.

Since owning a home was such a major force in the economy, not to mention the pride of home ownership, the government began to require banks to make loans to people who didn’t necessarily qualify under traditional circumstances. Moreover, mortgage bankers—who simply find loans to make and then sell those loans—ultimately saw that they were running out of people and businesses to make loans to.

If they didn’t create new markets, ey would be out of business. So mortgage companies would go to a group of investors and say something to the effect of: ‘‘Okay, you guys made a ton of money with our new 10 percent down purchase with a 600 credit score, but we’ve got a new one for you that’s just as profitable. How about 5 percent down and a 600 credit score?’’