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The United States mortgage market was considered one of the most advanced markets in the world. It seemed like the lenders there had figured out the alchemy of finance. It seemed like they had figured out a way to make the risks go away. A traditional market would have only a single type of mortgage. However, nontraditional markets such as United States had a wide variety of mortgages. Let’s have a closer look at the types of these mortgages in this as well as the next couple of articles.
In this article we will focus on types of mortgages from the lenders point of view. We will look at the pros and cons from a lenders point of view:
Prime loans were the traditional category loans. This meant that they were given to borrowers which could fulfill all the requirements i.e. they had a proper job, not much debt, had all their documents in place and had a good credit score. Also, these borrowers had enoush funds to put a decent amount of margin money into the loan account.
These borrowers would qualify for a mortgage under the most stringent standards. These are the people that would have got a mortgage 40 years prior to the subprime crisis when all the financial innovation was not present. Since these borrowers represent the least risk, these were called prime borrowers and the loans granted to them would be called as prime loans. Quasi federal agencies like Freddie Mac, Fannie Man and Ginnie Mae were allowed to purchase their loans from the lenders and then securitize them. Hence, the very low risk that these borrowers represented made them eligible for a very low interest rate called the prime interest rate.
The first category of loans with financial innovation is called A minus loans. These loans are granted to borrowers who may not have a good credit score. In this case a good credit score is defined as a credit score below 680. These borrowers usually have filed for foreclosures, bankruptcies, write-offs or such other unfavorable financial decisions in the recent past. This reduces their credit scores and hence they do not qualify for a mortgage.
However, lenders in the United States were of the view that loans could and should be made to these borrowers too! For this purpose, they increased the interest rate to offset the additional risk of default on these loans and started offering mortgages to these slightly delinquent buyers. However, these mortgages were risky and hence agencies like Freddie Mac, Fannie Man and Ginnie Mae would not purchase them in the secondary mortgage market. This changed when Wall Street investment banks started buying them from the secondary market. A minus loans formed one of the largest categories of loans that were securitized. Also A minus loans were at the heart of the crisis when the loans started defaulting.
A lower category of loans which are offered in the market were called Alt-A loans. These loans were very similar to A minus loans. In fact the similarity was so striking that some lenders would classify Alt A and A minus in the same category. However, there was a difference. Alt-A loans were given out to borrowers with insufficient documentation. This meant that they were given to people who did not have a regular job or business but on the other hand had sporadic or unconventional employment. They may or may not have a credit score less than 680. The lack of documents made them Alt A borrowers.
Once again the lenders charged a higher interest rate to reflect the higher risk of these loans. Once again the quasi federal agencies like Freddie Mac, Fannie Man and Ginnie Mae would not purchase these loans from the secondary mortgage market. However, Wall Street investment banks used a variety of credit enhancement techniques to make these loans marketable in the securities market. At the height of the subprime boom, Alt-A loans were amongst the most popular.
The next category of loans was given out to borrowers who had a bad credit history. These loans were made to borrowers who in the past had a track record of being unable to meet repayment schedules. These were people who had borrowed excessively often to the point of default. They were always a few months behind on their payment schedules and under normal circumstances these people would simply be denied loans.
These borrowers did not have any assets that could be used as collateral. Also they did not have enough money to make margin payments on the mortgage. In many cases, their houses were financed for more than 100% to allow them to meet the legal expenses as well as the expenses of moving into the house. These individuals could not possibly make the mortgage payments and maintain their living expenses from their known income.
Since these loans were on the verge of bankruptcy the moment they were made, these loans had a very high interest rate referred to as the subprime mortgage rate. These loans were purchased by investment bankers when the used the technique called “tranching” which will be explained in a later article. Federal agencies like Freddie Mac, Fannie Man and Ginnie Mae stayed away from these loans even at the height of the borrowing boom since their charter simply did not allow them to meddle with such loans.
In traditional lending environments, there is usually a single mortgage for every house. However, this was not the case during the borrowing boom. If a person had significantly more equity in the house i.e. the house was worth a lot more than the money owed on it, then the person could also take a second mortgage.
The second mortgage would usually be from a different lender and would be financed at a higher rate. The higher rate would reflect the additional risk that the second lender is taking by accepting being paid down only after the first lender is paid in full in the event of a default. Having two to three mortgages was common in the United States during the peak of the borrowing boom. Federal agencies such as Freddie Mac, Fannie Man and Ginnie Mae usually stayed away from these loans in the secondary mortgage markets. Once again these loans were consumed by Wall Street using the tranching technique.
Hence a lender during the borrowing boom had significant options to make loans. The types of loans stated above include pretty much every requirement of the borrower regardless of whether it would be sound lending practice to make these loans.
At that point in time, it was hailed as a financial innovation. However, when we look at it today, it seems like a house of cards built on a shaky foundation waiting to collapse and that was happened in the end.
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