5 Reasons the Subprime Market Crumbled
In 2000, as housing prices grew out of reach for buyers, more creative financing crept in and subprime lending became big business. Wall Street wanted its hands on more of these loans, and the hot housing market spawned a wave of new subprime companies. By 2004, 75 percent of borrowers were buying a home without using a down payment or proving income.
But by 2006 the subprime market started falling apart; Borrowers were defaulting on loans and subprime companies were going out of business. Bitner says these are some factors that caused the subprime market to crumble:
1. Greed. Mortgage brokers made more money if they sold loans with higher fees and interest rates. So borrowers would often be steered toward riskier products, even if a more traditional (and less risky) loan were available. "My income was directly proportional to the revenue I generated, and subprime was three to five times more profitable than any other type of loan we securitized," Bitner says. "I saw no logical reason to sell something that made less money and carried no competitive advantage."
2. Rampant fraud. Bitner estimates that more than 70 percent of all brokered loan applications submitted to his company were in some way deceptive, which meant everything had to be double-checked and verified. "The practice of massaging loans, making them appear different from what they are, became standard operating procedure," Bitner says. "With little accountability for their actions, brokers [were] left to decide how far they're willing to go."
Common cases of fraud included altering income documentation, giving a borrower an adjustable rate mortgage without explaining how it works, or disclosing lower rates and fees to a borrower but then increasing the figures right before closing.
3. No standards. Everyone wanted to cash in on the subprime business, even if they didn't know how the business worked. "With few rules and minimal consumer protections, abusive behavior flourished," Bitner writes. The number of mortgage broker companies increased by 50 percent between 2001 and 2006, peaking at 53,000 in 2006. Meanwhile, the number of new loan originators working for mortgage brokers grew by 100,000.
Yet no national standard existed for licensing mortgage brokers and loan originators. Bitner says the industry needs to raise its standards and develop a system for accreditation. "The recent debacle has given brokers a reputation similar to used car salesmen," Bitner writes. "Although the bankers and brokers associations don't have a history of working together on issues, a collaborative effort to accredit loan originators would be a key step to rebuilding credibility for the industry."
4. Securitization of mortgages. Mortgage securitization fragmented the industry, Bitner says. Previously, banks would provide the money to fund a mortgage, but with securitization, the funding got divided into several components.
Here's how it works: Brokers originate the loan, a mortgage lender funded it, and a lender then sold it to another financial institution or used an investment bank to package it into a mortgage-backed security. Investors then bought them for their portfolio. "The problem in today's housing market exists because the investment banks packaged high-risk loans into securities and the rating agencies assessed them as investment quality," Bitner writes. "If the investors who purchased the securities understood what they were buying, the outcome would likely have been different."
5. Ultra-relaxed underwriting standards. As the subprime market took off, a pricing war among subprime lenders emerged. In order for lenders to keep their revenues up, they needed to fund more borrowers, leading to less restrictive underwriting. "It's easy to lose sight of what constitutes a good credit risk when you spend all day looking at marginal deals," Bitner writes.
Indeed, riskier products emerged, such as loans that required no down payment, proof of income, or even a history of paying rent. One loan product even allowed borrowers with credit scores of 580 and a 90-day-late payment in their housing history to qualify for 100 percent financing.