The Subprime Mortgage Crisis

There continues to be a lot of talk about the subprime mortgage crisis and the economic rippling effect it has on the US and global banking systems.

To better understand, in simple layman's terms, what the subprime mortgage crisis is about, let's review from the beginning, how it appears to have started.

Subprime Lending

Subprime lending, sometimes called non-prime, or second chance lending, is lending at a higher rate than the prime rate. In the US, subprime mortgages refers to mortgages that do not meet Fannie Mae or Freddie Mac guidelines. Borrowers who cannot qualify for regular loans or mortgages due to poor credit ratings or high debt load, can access more credit through subprime loans. Subprime lending can be risky for lenders as well as borrowers. With high interest rates and often poor credit scores and credit history, subprime car loans, and subprime credit cards can further jeopardize the borrower.

Subprime lending has been a controversial subject for some time, with opponents suggesting that these practices target the most vulnerable who could not understand what they were signing and could not possibly meet the terms of their loans. Many subprime loans frequently lead to default, seizure of collateral, and mortgage foreclosure.

Prior to 2005-2006, mortgage lenders were competing with each other to gain a bigger share of the mortgage market. To that end, many became very lax in there lending requirements and as well, were offering low introductory mortgage rates to gain real estate buyers' business. Homebuyers who, under conventional and more stringent lending policies would never have been able to qualify for a mortgage, took advantage of the situation and dipped their toes into the real estate market. The pent-up demand for houses created a buying frenzy and a housing bubble was created.

Unfortunately, when those "low introductory mortgage rates" reverted to the normal market interest rates, many of these new homebuyers could not maintain the higher payments and mortgage foreclosure became inevitable. (Added to this dilema, builders who had been constructing houses as quickly as they could, were now left with a surplus of new homes ... in a market where prices were declining rapidly in many areas.)

The subprime mortgage crisis and the practice of subprime lending in general, has led to a credit crunch, a restriction on the availability of credit in world financial markets as well as here at home. Large numbers of borrowers have defaulted on their loans, filed for bankruptcy or are in mortgage foreclosure. Though there is no consolation, hundreds of subprime lenders have closed shop, filed for bankruptcy or been acquired by larger lending institutions.

The following is a chart outlining the impact of the subprime mortgage crisis from the homeowner up to the government and central banks.

Diagram of Subprime Crisis Legend
ARM = Adjustable rate mortgage
CDO = Collateralized debt obligation
Fed = Federal Reserve System
MBS = Mortgage-backed security

More about the subprime mortgage crisis, the housing bubble and the credit crunch here.