A Closer Look at Foreclosure: Part II

In "A Closer Look at Foreclosure: Part I",  I mentioned about the increase in foreclosure in the subprime portion of the mortgage market and  how it escalated to a crisis that had a widespread effect in the US financial market and other global markets.

So how did this happen?

Reading this article in NYTimes, "Inside the Upside-Down World of the Short Sale" , I had a better understanding of foreclosure and the subprime crisis.  It discussed the real life stories of individuals facing foreclosure and those who are legally earning  money from their misfortune through short sale. Moreover, I understood the different scenarios that led this people to face foreclosure.

Most of the people facing foreclosure took subprime mortgages.  Their poor credit history won’t enable them to qualify for any prime mortgage, so they took chances in a subprime one.  If you think about it, it doesn’t make any sense to lend to people whom you consider as high-risk borrowers and give them higher interests at the same time.  If they cannot qualify for the lower repayments, what makes them more qualified for the higher repayments?

It all boils down to doing business.  The higher the risk of an investment, the higher the returns.  The subprime loans were made possible by the securitization of mortgages. Many lenders and banks no longer hang on to the majority of the loans they issue.  It’s sold to investment banks, which offers them as securities to investors. In the last few years, investors through hedge funds, pension funds and university endowments purchased a lot of these subprime mortgage securities.  They thought it was a sound investment in spite of the significant risk of default of subprime borrowers.  The high interest rate made it look attractive to investors.

The whole process made it a recipe for an inevitable decline in mortgage standards.  As stated in the article "Banks were acting as middlemen, their incentive to vet borrowers declined strikingly."

A lot of the borrowers, financial institutions and investors involved in the process became a victim of their own false assumptions of the risk involved. Borrowers thought that as long as they get their loan approved everything else will follow. Financial institutions thought that this segment of the market can be a lucrative business for them. Investors thought that the high interest rate can bring them high returns.  Although, there were a few who met their goals, a lot suffered in the subprime mortgage meltdown.

Foreclosure became a vicious cycle:

Borrower defaults in mortgage payments =>

Bank repossess home, unloads it as quickly as possible =>

Increases the inventory of homes for sale =>

Increase in supply, together with the unstable market conditions =>

Lead to a decline in prices =>

A lot of those having financial hardship cannot refinance their home because the amount of their mortgage is bigger than the actual value of their home =>

If they cannot save their homes through other options =>

There’s no other way out, but to face foreclosure.

The latest increase in foreclosure statistics and subprime crisis is truly a tragic event for a lot of people affected.  Hopefully, the lessons learned will lead to better lending standards, a better understanding of the risks involved for the subprime borrowers and a better regulation of subprime securities before offering it to the investors.

Are you one of the people who got involved in the latest subprime crisis?  How did it affect you?