Sub-prime mortgages have been a crucial element of the real estate boom of the last few years. While in 1994 only 5% of mortgage originations were subprime, in that last two years 20% of all mortgage originations have been subprime. Note also that interest-only and payment-option ARMS – many of which are to subprime borrowers - were 2% of loan originations in 2000; while by 2006 they accounted for 40% of loan originations. So what happens in the subprime market is of great importance for developments in the housing market in 2007. 

The latest news – discussed in previous blogs of mine - are that both subprime lenders and borrowers are increasingly in trouble. On the lending side at least four subprime lenders have gone under in the last couple of months. Other major subprime lenders are rumored to be on the way to bankruptcy or are on the selling block.   

One interesting open issue is what will be the effect of the closing down of subprime lenders'operations – several until now, many more most likely in 2007 - on the access to mortgages of subprime borrowers. Regulators are starting only now to crack down on these “monster mortgages” (as defined by Business Week) that a colleague of mine expert in the subject aptly - if a bit hyperbolically - referred to as an “ unregulated scam where a bunch of con artists lent to a bunch of deadbeat borrowers”. They were indeed “monster mortgages” as, until recently, you could borrow with zero down-payment, with declaring your income and the lender not checking it, with interest only loans, even lower teaser rates and even negative amortization.

Calling this entire system an "unregulated scam" is certainly excessive and exaggerated but the above metaphor captures some of the excesses of the last few years. And now this entire house of cards is coming down crashing.  One of the important questions is whether the financial distressed of the lenders - together with tighter regulation - will lead to a credit crunch for the borrowers. The lenders who are going under are not the largest players in this subprime market (even if they were still significant players) but, as they were most likely funding the marginal home buyer (the one that even HSBC and Citi were unwilling to provide with a subprime loan), the impact of their closure may be much larger than their size. And the fact that these failing subprime lenders operations spanned very different geographical areas (California, Virginia, Connecticut or the entire US for the case of Ownit) suggests that the impact of this upcoming credit crunch may become national. 

Note that the bust of the commercial and residential real estate sector in the South in the late 1980s led to the S&L crisis; and this S&L crisis led to the credit crunch that was one of the important factors behind the 1990-1991 recession.