Subprime Lending Crisis -Another Perfect Storm

Subprime Lending Crisis -Another Perfect Storm?

"Subprime loans" are loans to low quality, high credit-risk borrowers. Because of that higher risk, lenders of such loans always charge higher rates of interest and demand stricter terms.

At this moment, certain elements of such loans have caused a crisis in the United States economy - and thus in other world economies as well. We cannot yet know how bad it will be, but it is quite serious and it affects all kinds of financial institutions. Here is a short explanation of why this happened, based on my years of experience with such loans.

At one time, I was the second-ranking lawyer and perhaps the chief "legal troubleshooter" at the leading subprime lender in the United States, Household Finance Company. When I was at HFC, renamed as Household International, Inc., it began to offer second mortgages on houses.

The 1990's saw two changes in this business that - together with even more recent changes - greatly increased the risks for the subprime loan industry and the economy as a whole. First, consumer loan companies started offering full mortgages to homebuyers, and especially to subprime borrowers. Also, many more new companies entered that subprime market.

Second, a practice arose called "securitization," of transferring bundles of such mortgages to a different company or trust and selling shares or bonds of that entity ("mortgage-backed securities") to other financial institutions such as banks, insurance companies, pension funds and hedge funds. Because the loans bore higher interest charges, buyers expected much more profit and thought that bundling meant a group of such loans would have lower risk than a single mortgage.

Another change came in 1995, when a government policy in-creased home ownership by permitting new types of housing loans with lower monthly payments, such as "interest-only" payments, longer 40 or 50 year terms, very low initial interest rates, etc. This stimulated home ownership so much that by 2004, it had reached the extraordinary level of 70%.

The change that created the "perfect storm" took place around the end of 2005, when this larger group of mortgage lenders changed from competing via lower rates (because their cost of funds was rising) to getting business by ignoring their credit requirement guidelines. In fact, many of them made foolish loans.

Foreclosures rose dramatically, investors started to write off large parts of their subprime portfolios and more than 100 lenders failed or entered bankruptcy. Even worse, it became clear that the $6.5 trillion mortgage-backed securities market was collapsing and the extent of the ultimate meltdown could not be measured.

This crisis is not only a one-country problem, because many international banks and funds (including ones in Japan) have invested widely in subprime mortgage-backed securities issued in the United States. While both Japan and the United States economies remain strong, this will continue to exert downward pressure until the extent of the investments becomes clear.