During the late 1990s and early 2000s,
the prices of homes rose quickly, helped along by low interest rates, buyers with strong incomes and banks offering easy lending terms. “The rapid increase in housing values gave lenders a false sense of security and meant that some companies were writing loans to people who ordinarily wouldn’t have qualified,” says Jill Aleshire, director of consumer banking at Thrivent Financial Bank.
Adjustable-Rate Mortgages—One of the financing tricks lenders used was an adjustable-rate mortgage, or ARM. Such loans offered a rate that started very low but later reset to a much higher rate, typically within a year or two. While some consumers with good credit took on adjustable-rate mortgages, ARMs more often than not went to higher-risk consumers. • According to Mark Simenstad, who watches the debt market as Thrivent Financial’s vice president of fixed-income mutual funds, perhaps 30 percent of the mortgages written in 2006 and 2007 were subprime—written to consumers with greatly variable income, unsubstantiated income or poor credit ratings.
Wall Street Weighs In—Eager lenders weren’t the only ones enthused about the money to be made with subprime loans. Large Wall Street investment banks and investors, including banks, brokerage houses and insurance companies, were hungry for a cut of the pie. • They satisfied that appetite by pooling loans into securities and investing in bonds backed by money from pools of subprime mortgages. By securitizing groups of mortgages, investors made easy money when the market was flooded with new loans. Lenders who sold these loans to the investors received money that they could use to generate new loans.
The Catch—On the surface, it seemed like a win-win for everyone involved, but there was an important catch. These investments—backed by thousands of mortgages—are only valuable if the homeowners make their loan payments. When the housing market began to stall in 2006, some homeowners had trouble making monthly payments. • As the low introductory teaser interest rates on ARMs reset to higher rates and payments started to grow, “the adjustments really began hitting people who had less financial flexibility,” Simenstad says. • More than a few percentage points, these rate changes were quite dramatic, sometimes taking typical loans from 7 percent or 8 percent up to 12 percent or 13 percent, notes Greg Anderson, senior portfolio manager at Thrivent Financial.
Financial Fallout—Many who planned to dump their risky adjustable-rate loan and refinance at a lower, fixed-interest rate discovered, too late, that they didn’t qualify for a new loan—lending standards had tightened. Some mortgage holders who couldn’t make their payments tried to sell. But many had the same idea, and a glut of properties drove housing prices down in many areas. • For many, the only option was foreclosure. In fact, the percentage of foreclosures in the first quarter of 2007 was the highest since 1979, according to the Mortgage Bankers Association. • As more individuals lost homes, lenders fell on hard times, and once-eager Wall Street investors shied away from anything backed by the risky subprime mortgage money pool. The real estate and financial markets continue to fluctuate today as they react to problems in the subprime mortgage market.