S.O.S. Sorting Out Subprime

Does distress in the housing market spell lasting trouble or has it created prime opportunities to put your money to work?

Barring the economy slipping into a recession, it appears that the subprime situation may present a classic half empty/half full scenario for investors.

The Subprime Stone
It’s abundantly clear to many market watchers that maintaining low interest rates for such an extended period naturally fuels speculation and risk-taking. So why did it seem that most of Wall Street was taken off guard when cracks appeared in the subprime foundation?

One key factor is that many of the mortgages offered to subprime borrowers were relatively new creations. “The option adjustable rate mortgages and the interest-only mortgages, etc., had never really been rolled out in such volumes,” says professor Raphael Bostic, director of the Master of Real Estate Development program at the University of Southern California in Los Angeles. “In particular, we had never seen how they performed in periods of [economic] stress.”

These new products were introduced as lower interest rates fueled the housing boom and lenders looked for ways to maximize their participation. As they sought a larger piece of the housing action, many lowered their credit standards. At times, adjustable rate mortgages were made without regard to the borrower’s ability to repay once the low introductory teaser rate was reset to a higher level. The reset often resulted in a substantial increase in the monthly mortgage payment, making for an unaffordable burden.

Because their low introductory rates made homeownership more affordable, adjustable rate mortgages increased in market share. Now, many are pointing their fingers at mortgage brokers for pushing these products to subprime borrowers. They claim a number of brokers made assurances that it wouldn’t be a problem to refinance before the interest rate reset–typically within two to five years. However, as the market softened, it has become difficult to refinance. The end result: Many face foreclosure.

The rising foreclosure rate will have a significant impact on African American homeownership, which has declined slightly in recent years and remains below 50%. Studies by the Durham, North Carolina-based Center for Responsible Lending and the Washington, D.C.-based National Community Reinvestment Coalition have analyzed mortgage origination data revealing that African American borrowers are more likely to receive high-cost subprime loans. And it’s not just a low-income phenomenon. In fact, the NCRC study, Income is No Shield Against Racial Differences in Lending, found that in 159 metro areas across the country, more than 40% of the loans to middle- and upper-income African Americans were high cost. Because “subprime” refers only to the interest rate attached to the loan, it’s important to remember that they can be fixed-rate or adjustable-rate mortgages. Similarly, it’s important to note that while such disparities must be addressed, it’s unwise to speculate as to how much of the difference can be attributed to predatory lending.

All the while, as housing values climbed, investors sought to participate in any way they could. Wall Street satisfied that demand by churning out mortgage-backed securities. “Increasingly in recent years, mortgage lenders have shifted from lending money and holding the mortgage to lending money and then pooling the mortgage with

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