We hear about the subprime mortgage crisis daily, but are you too embarrassed to admit you don't understand what the fuss is all about? What exactly is this predicament the nation finds itself in? How did this debacle arise, and does it affect you? To answer these questions, let's start at the beginning...

Understanding Mortgage Lending

Traditionally, mortgages were financed by banks. This meant that a bank was limited in its lending based on the deposits they received from their customers.

Recent changes to this model, however, paved the way for the current situation to arise. Banks moved to a new lending model in which the mortgages they held were sold to the bond markets. This freed banks from lending based solely on their customer deposits.

The boon to this new model was that more money was available to help people buy homes. The downside, unfortunately, was that banks no longer had as much pressure to verify that the mortgages they issued were solid. Knowing that the mortgages they created would eventually be sold, banks took on riskier loans than would have been prudent in the more traditional lending era.

The Mortgage Bond Market

Until recently, the mortgage bond market was heavily dominated by government-sponsored agencies such as Freddie Mac. Since 2002, however, the private sector asserted itself in this market with a vengeance.

With new mortgage vehicles such as jumbo loans, and sub-prime loans to borrowers with poor credit histories and/or weak documentation of income who were rejected by prime lenders like Freddie Mac, the private sector significantly increased its role in the mortgage bond market.

The rise of private sector participation catapulted the mortgage bond market to a worth of $6 trillion, making it the largest part of the $27 trillion bond market. The mortgage bond market is now even bigger than the Treasury bond market.

Foreclosures Emerge

Many homeowners were lured by brokers selling subprime mortgages who explained that the equity in homes could be turned into cash by refinancing. What brokers failed to explain in many cases was that the mortgage interest rates would double after 2 years.

A wave of foreclosures began appearing, first in inner-city areas, then across the entire country, starting in 2005.

By that point, 20% of all mortgages were subprime. They were especially popular among recent immigrants in the competitive housing markets in New York City, Arizona, Nevada, Washington, D.C. suburbs, and Southern California.

Consequences

Foreclosures are predicted to rise over the next two years as many sub-prime mortgages fall outside of their initial 2-year period, causing interest rates to become variable and, in many cases, double. It is estimated that as many as 2.4 million homeowners are in danger of foreclosure because of subprime loans.

The dramatic rise in foreclosures has had such a strong impact on the price of homes that we now see the first national decline in housing prices since the 1930s. A glut of 4 million unsold homes is depressing prices, forcing builders to lower prices to rid themselves of remaining inventory.

The building industry, comprising 15% of the economy, is expected to halve its output, causing a loss of over one million jobs. Related industries such as manufacturers of durable goods, e.g. washing machines, home improvement stores, furniture makers, may also take a hit.

Banks and the bond market are also feeling the crunch. Banks have already lost $60 billion, and bondholders (such as pension funds) who have bought subprime mortgage bonds have seen a sharp fall in value of those instruments. Estimates of the total financial loss for these institutions run as high as $450 billion.

Since lenders have suffered badly, they are more stringent with any new loans they make, resulting in a tightening credit supply for consumers. Mortgages, especially non-traditional ones such as subprime and jumbo loans, are now more difficult to obtain.

Buying and Selling Real Estate During the Crisis

The crisis has reached historic levels. President Bush signed The Mortgage Forgiveness Debt Relief Act of 2007, Congress has pushed through tax rebates, and the Fed has lowered interest rates sharply all in response to the weakening of the economy caused in large part by the subprime mortgage crisis.

In these unsure economic times, acquiring the services of a qualified real estate professional to navigate your local real estate market is more important than ever. Regardless of whether foreclosures have increased in your neighborhood, the psychological effects of the subprime debacle have been felt everywhere. With the help of a realtor, however, you can determine the best strategy for buying or selling a property so that you not only survive the current real estate market situation but perhaps even profit in spite of it.

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