Subprime Slump: Will the Economy Follow?

On February 7, 2007, the Senate Banking Committee heard testimony
which indicated that nearly 20 percent of subprime mortgage loans
obtained in the period from 2005-2006 will result in foreclosure,
affecting over 2.2 million families in the United States over the next
few years. [1]  On Monday, April 2, 2007, the second largest provider
of high-risk, subprime mortgages, New Century Capital Corporation of
Irvine, California, filed for Chapter 11 Bankruptcy protection and
fired 3200 employees in the wake of its own "financial missteps" and
trouble with the SEC and U.S. Department of Justice over financial
statements which failed to accurately account for financial losses the
corporation was suffering, as well as mismanagement of the
corporation.  [2]  With more than 25 subprime lending companies
shutting down over the past few months [3], many are wondering about
the implications for the future of both the subprime market and the
economy.

Subprime mortgages
are those given to consumers with credit scores below 620, indicating
that these consumers are generally late in paying their bills and often
have significant delinquencies in their credit reports indicating
frequent late payments on obligations of 30 to 90 days. [4] 
Alternatively, subprime mortgages are issued to consumers with high
debt-to-income ratios or with limited credit histories. [5]  As
compared to prime borrowers, "subprime borrowers are disproportionately
minority and lower income, older, less well educated, less financially
sophisticated, and less likely to search for the best interest rate."
[6]  This indicates that subprime mortgagees may not fully understand
exactly what they are getting themselves into contractually and
financially at the time they sign their mortgage documents.

Though these mortgages are issued to first time homeowners, a
majority of the subprime loans are refinancing mortgages used for home
improvements or as an alternative to other types of consumer credit. 
[7]  Subprime loans have higher interest rates than prime loans, and
tend to have less desirable terms such as penalties for prepayment of
the mortgage balance or balloon payments which require a borrower to
pay off the entire balance of the loan after a certain period of time
has passed. [8]  These loans also tend to have lower initial payments
or interest only payments in the first months or years of the loan,
followed by much larger monthly payments after the initial months or
years have passed. [9]

Currently, with many subprime mortgage companies closing their doors
because of relaxed lending standards resulting in a high rate of
default, approximately 14% of the $1.2 trillion in outstanding subprime
mortgages are presently in default [10], with that number continuing to
rise.  In addition, according to the director of the Federal Deposit
Insurance Corporation Division of Supervision and Consumer Protection,
Sandra Thompson, one million adjustable mortgages will increase in
interest rates and payments this year with another 800,000 increasing
in 2008. [11]  Increases in monthly payments over the next few years on
all of these mortgages can only lead to many more defaults as these
mortgagees struggle to make payments with the increased demands on
their finances.

With the so-called "crisis" in the subprime market beginning to
unfold, much focus has been shifted to predatory lending practices
which often involve glorified scams to lure unwary homeowners into
refinanced mortgages with terms that violate anti-predatory lending
legislation.  A simplistic example of these practices can be seen in
the story of one resident of Miami, Florida, who was struggling on her
mortgage when she was "sweet-talked" into a deal based on what she
believed were "race and religion . . . 'affinity marketing' tactics" in
which the lender promised a new mortgage would relieve her financial
struggles and give her a fresh start. [12]  Instead, she got a
refinanced mortgage that took her $85,000 loan at 8.5% interest and
exchanged it for a new loan worth $234,000 at 11% interest, which
doubled her monthly mortgage payment to over $2200. [13]  Mortgagees
like this who are struggling to make payments on their existing
mortgages and are scammed into even higher monthly payments from
predatory lending practices are bound to suffer default and contribute
to the growing subprime mortgage crisis.

Not only are these increased rates resulting in defaults on
mortgages and subsequent foreclosures on homes which will continue into
the coming years, but these defaults are also affecting capital
markets.  With publicly traded corporations who issue these subprime
mortgages filing for bankruptcy (such as New Century Capital
Corporation) shareholders in these corporations are suffering huge
losses on their investments, causing a decline in their personal
investment portfolios.  In addition, the subprime market has thrived in
issuing bonds backed by subprime mortgages, losses of which were
estimated at 7% to 8% for 2006 [14], which can only be expected to
increase as the number of defaults in loans backing these bonds
increase. 

Thus, it seems clear that the crisis in the subprime mortgage arena
has carryover effects to much of the economy including housing markets
as well as capital markets.  As more subprime mortgages enter default
and foreclosure, it seems that the effects on the economy can only be
expected to worsen.

Sources

[1] Legislative Highlights, "Oversight Congress" Gets Busy Putting Leaders on the Defense, 25-2 Am. Bankr. Inst. L.J. 8 (2007); Sue Kirchoff, Regulators:  Oversight of Subprime Mortgages is Lax, Mar. 22, 2007, http://www.usatoday.com/money/economy/housing/2007-03-22-subprime-hearings_N.htm?csp=34 (last visited Apr. 3, 2007).

[2] Gary Gentile, Major Home Lender Files for Bankruptcy, Apr. 2, 2007, http://news.yahoo.com/s/ap/20070402/ap_on_bi_ge/new_century_bankruptcy.

[3] Id.

[4] Bankrate.com, Mortgage Basics:  Subprime Mortgages, http://www.bankrate.com/brm/green/mtg/basics2-4a.asp?caret=8 (last visited Apr. 3, 2007).

[5] David J. Weiner, Assignee Liability in State Predatory Lending Laws:  How Uncapped Punitive Damages Threaten the Secondary Mortgage Market, 55 Emory L.J. 535, 539 (2006).

[6] Id. at 542.

[7] Id. at 540.

[8] See Bankrate.com, supra note 4.

[9] See Gentile, supra note 2.

[10] Kirchoff, supra note 1.

[11] Id.

[12] Jim Loney, Subprime Crisis Exposes Mortgages Scams, Reuters, Mar. 26, 2007, http://www.reuters.com/article/bondsNews/idUSN2123569120070326?pageNumber=1.

[13] Id.

[14] CNBC.com, U.S. Subprime Bond Losses May Reach 8%, http://www.cnbc.com/id/17850711 (last visited Apr. 3, 2007).

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