Subprime Mortgage Impact

The typical mortgage scenario used to be you bought a house, got a mortgage and spent the next 30 years paying it off. So what’s all the uproar about the subprime mortgage meltdown and how does some guy defaulting on his mortgage impact you?

Subprime mortgages are typically offered to consumers who have a poor credit rating or high debt. When lenders provide mortgages to these consumers with damaged credit, they charge higher rates, which are typically two to three percentage points prime-rate loans. Lenders often offer initially low teaser rates, which increase over time.

After they complete arrangements for the mortgage, lenders (or originators) sell the mortgage to a bank. This brings in cash, so they can make more loans. The banks, in turn, repackage or combine the loans with others and offers them as mortgage-backed securities. Hedge funds, insurance companies and other investors buy the securities since they usually offer better returns than Treasury or corporate bonds.

When defaults are low, everyone benefits. Unfortunately, the number of delinquencies for subprime mortgages is at the highest rate ever, for loans of a similar age, according to New York-based Bear Stearns Cos.

When subprime defaults rise, the first to be hit are the mortgage originators, since they often have an obligation to make good on the loans that they offer to banks if they default in the first three months. Since the start of 2006, over 20 subprime mortgage companies have shut down or been sold, according to data compiled by Bloomberg. The chief economist of the Mortgage Bankers Association predicts that more than 100 lenders will go out of business during 2007. Many of those who fail will be subprime lenders.

The trickle down impact on the economy continues as banks react to the defaults become more reluctant to lend money. When banks clamp down, the overall economy suffers because it's harder for businesses to finance expansion and consumers to get loans.