Borrowers and lenders reap
consequences in mortgage lending

The current subprime mortgage crisis is unique because it affects both borrowers and lenders.  Both groups believed the good times of the bullish real estate market would continue to roll—not anymore.

The upward momentum of housing prices has reversed with individuals and financial institutions severely impacted. How did this state of affairs come to exist?

Two recent ABA CLE programs looked at the current situation in search of answers.  The first, "Subprime in Prime Time:  What Business Lawyers Need to Know About the Subprime Mortgage Crisis," examines the underlying changes to securing mortgages that led to today's real estate market woes.  The second, "The Subprime Lending Industry: Bankruptcy Issues Raised in the Restructuring of an Industry," details the repercussions of the current crisis on the home mortgage industry.

Subprime lending refers to making mortgage loans to individuals who have less than perfect credit.  Traditionally, individuals or families needed to have a minimum of 20 percent in cash to put down on a home as well as exceptional credit to qualify for a mortgage.

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As the profitability of mortgages increased, loan originators as well as banks steadily increased the pool of mortgage holders by making loans to those whose credit was less than perfect, or subprime.

Richard F. DeMong, the Virginia Bankers Professor of Bank Management, McIntire School of Commerce, University of Virginia, points out in "Subprime in Primetime" that the current crisis stems from the transfer of risk.

In the current mortgage situation, banks or loan originators sold mortgages to packagers who in turn sold groups of mortgages to investors in the secondary mortgage market.  At each stage in the transaction, the new owners of the mortgages believed that another party had taken on most of the risk and that they had no risk themselves.

DeMong points out that transferring risk leads to changes in behavior and that these changes can lead people astray. 

Several factors contributed to the current crisis, he notes.  Lowering credit standards, teaser rates, overly optimistic borrowers and investors, and fraud are all involved.  Many borrowers took on obligations greater than they could afford because of the attractive very low interest rates they received initially.  The thinking seemed to be that their income would go up so they could manage the payments and the value of the property would likewise increase so they could sell the property at a profit if they payments became too burdensome.

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At the same time, investors became accustomed to regular dividends on their mortgage-backed securities.

When rising interest rates and declining home prices impacted the ability of borrowers to continue making payments, investors began exiting the market.

The "Subprime Lending Industry" program further looks at the dynamics that created the current crisis and the results for lenders.

Questionable practices, such as the use of the "no doc" loan, attracted mortagage applicants with dubious qualifications. No doc means that the buyer or buyers state their income and that the loan originator takes their word without asking for documentation.  Too many individuals exaggerated their incomes to qualify for a larger mortgage in order to afford a bigger home.

Coupled with artificially low initial rates, these loans undermined the solidity of the mortgage market.  Once individuals failed to meet their obligations, investors began backing away from mortgage securities, causing the market for subprime mortgages to decline.  Some originators are unable to place lower-rated mortgage securities with investors and some originators are finding that it cost more to originate loans than the selling price.

The result is that 15 out of the 25 top subprime mortgage lenders in 2006 have either been acquired, are seeking buyers or have shut down.  Those subprime lenders who are still in operation have implemented new underwriting, operational and portfolio controls to manage their exposure.

There is talk of both congressional action and the promise of far greater controls at the front end to prevent the subprime crisis from spreading to other parts of the economy.

The ABA CLE of "Subprime in Primetime:  What Business Lawyers Need to Know about the Subprime Mortgage Crisis"  is available at http://www.abanet.org/cle/programs/t07spt1.html.

The ABA CLE on "The Subprime Lending Industry: Bankruptcy Issues Raised in the Restructuring of an Industry" is available at http://www.abanet.org/cle/programs/t07spt1.html. Materials are available at http://www.abanet.org/cle/programs/nosearch/materials/2007/t07tslcm_intro.pdf.

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