“Subprime” is a name given to loans that are riskier than regular loans, so they carry a higher interest rate. They are called “subprime” because they are less than (“sub”) prime. People who would not normally qualify for a big mortgage receive these special loans. They were marketed as “affordability” instruments, meaning they “enabled” people to buy houses that cost more than they could afford. These loans had “teaser” low initial rates, also called “qualifier” rates, which would go up after a period of time, most even rising beyond the point that the borrow can “afford.” Some of these loans even allowed borrowers to qualify for the loan using “stated income,” meaning they would use whatever the borrower SAID their income was to see if they could afford the loan. (For some reason, these became known as “liar loans.”)
Why is “more than they can afford” a consideration in giving a loan? It is possible that this term is used because the payments on such loans are “more” than the borrower can “afford” – meaning that the borrower will not be able to make the payments after the initial low-interest-rate period ends. When a borrower can’t make the payments, it is called “defaulting” which means they “default.” Which also means they can’t pay back the loan, lose the house, and face financial ruin for the rest of their lives. And the lender is stuck with a “bad loan” meaning they are not going to be paid back.
When a lending company has enough “bad loans” on their books, THEY are also in trouble and can go bankrupt, which is happening. After enough of these go bankrupt the companies that loaned money to them also start to go bankrupt. This ripples through the economy. (Hint – if you have any money in “money market funds” see if the account can “lose principal” which means if it turns out the money-market “instruments” that generate the income are from companies with mortgage-based loans out there, or loans to companies with mortgage-based loans, these “instruments” can go bad your money enters a highly technical state known as “going away.”)
ONE way this ripples through the economy is that lenders are forced to “tighten up” their requirements – meaning they STOP giving loans to people who cannot “afford” the loans. This reduces the number of people who are looking to buy a house (demand) at exactly the same time as the market is flooded with homes for sale because the owners cannot make the payments on their loans (supply). So there is a combination of high supply and low demand, which must force prices to drop. A lot.
And here we are today, as it turns out that the borrowers who could not “afford” the loans actually could not “afford” the loans – they can’t make the payments, which in plain English means they “can’t make the payments.” And the lenders are starting to go bankrupt, one by one. And it will ripple through the economy.
See The Bonddad Blog: Anatomy of a Subprime Default,
Short version of all this — it’s a big damn mess.
Update – This story JUST hit the wires:
New foreclosures at record high
Mortgage delinquencies rise across the board in fourth quarter,
Many more U.S. homeowners were unable to keep up with their mortgage payments in the fourth quarter, the Mortgage Bankers Association said Tuesday, with the rate of homes entering the foreclosure process hitting a record 0.54% and the delinquency rate on U.S. home loans leaping to 4.95% from 4.67% three months earlier.
… The rise was led by subprime mortgages, where delinquencies increased to a seasonally adjusted 13.33% from 12.56%, and FHA loans, which saw a record-high delinquency rate of 13.46%. Trouble in subprime mortgages, made to borrowers with the riskiest credit, has roiled lenders and the stock market in recent days.