A thought came bouncing into my brain this morning... about the "sub-prime" crisis, and all the foreclosures that have followed, and are continuing to follow. I have thought about this on and off... throughout my entire real estate career.
It all has to do with how the sub-prime loans are put together in the first place. Many of them are set up for the increased likelyhood of failure... from the "get-go."
Just what is a "sub-prime" loan ? It is simply a loan that is made to buyers that are not "prime" buyers. They are buyers with questionable credit scores, or short job history, or buyers with high debt to income rations, or buyers that for some reason or other... are less desirable borrowers... as far as the lenders are concerned.
Lenders lend mony for one reason... To Make Money. Nothing wrong with that. Making money is a good thing. I think everyone who works a job, or invests in something or other... should make money from doing it.
Lenders lend money... mortgages... on the basis of one thing, and one thing ONLY. That one thing... is "risk." The lower the risk... the quicker the loan is approved. The lower the risk... the better the interest rate will be for the borrower. These borrowers are "prime" borrowers. Lenders lend to them very quickly... because of the extremely low risk... and because there is a much smaller chance... much smaller... that the mortgage loan in question will ever go into "default."
When a lender considers making a loan to a borrower who is a greater credit risk... of course they hesitate in making the loan. The RISK is greater, so the possibility of default is greater.
So... what does the lender do ? When they see that making a certain loan has a greater risk to it... they look at the risk, and often decide that IF... they can make a higher profit on that loan... by charging a higher interest rate... anywhere from two percent to five percent higher... or even higher than that... sometimes they decide to make the loan. The higher the return for them on the loan, the greater risk they are likely to take.
Sometimes in addition to charging the "riskier" borrower a higher interest rate, they also charge the borrower "points"... to increase the "yield" of the loan... which, of course, makes making the loan more profitable for them. A buyer who get this type of loan... has a higher interest rate... which means his payments are higher... which of course makes it more difficult for him to make his mortgage payments.
They lenders figure that the increased risk might be worth it because of the higher rate they make, and the one, two or more points they get at closing... right up front.
Finally... I'm getting to the point of all this ! Whew ! So, from day one, the "high risk buyer" gets a higher interest rate, and sometimes they get charged extremely high loan fees (which depletes their "cash reserves"). Both of these things make it much more difficult for the "high risk" borrower to make their mortgage payments. It's almost like they are set up for failure... right from the beginning.
A final problem with this type of sub-prime loan... is that the loan... if it is a conventional loan... often does not have an "escrow account." This means that the taxes and insurance are not collected monthly. What it also means is that this riskier buyer with depleted cash reserves gets faced with having to come up with a huge chunk of money at the end of each year... to pay their real estate taxes. Many, many times... this is impossible for them to do.
I do not have any ideas or answers to this.
Perhaps the lenders may decide not to make these higher-risk "sub prime" loans. But, when they do that... they cast aside the higher return on those "risky" loans... which in turn lowers their profit. That... in turn... throws a giant monkey wrench into the wheels of the overall economy.
What to do, what to do ? The only way I can see out of this... is for the lenders to make more money on the "prime" loans... to build up their "corporate reserves..." to help them cover their losses when the defaults start happening. If higher lender reserves were required, fewer lenders would be in such deep trouble. A mortgage company that goes under... helps no one.
And... ironically... the lenders who set these sub-prime borrowers up for failure... are also setting themselves up for failure by so doing. Why can't they see how backwards this all is ?
In the mortgage industry... just as in so many other things in life... there must be a "balance." How to achieve it... seems to be the big "sub-prime" question of the day !