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Subprime mortgage loans: According to the U.S. Department of Housing and Urban Development, “subprime” mortgage loans are those designed for “persons with blemished or limited credit histories. The loans carry a higher rate of interest than prime loans to compensate for increased credit risk.”
Subprimes first appeared in the early 1990s to bridge the financial gap for populations that historically had struggled to develop good credit and save for the 20 percent down payment required under the terms of traditional home loans. Federal policy under the Clinton and second Bush administrations supported the expansion of these loans to drive up ownership among low-income and minority home buyers. Looser regulations permitted the creation of complex mortgage products that featured lower down payments and adjustable interest rates. This also encouraged many buyers to purchase homes beyond their means. The National Association of Affordable Housing Lenders has estimated that as much as 30 percent of subprimes were issued to buyers who could have qualified for safer, cheaper “prime” loans.
Eventually the regulatory door swung wide to abuses. “Not every subprime loan is a predatory loan,” says Judith Fox, Notre Dame professor of law, but she has encountered brokers who falsify clients’ income, press for inflated appraisals, charge spurious fees, conduct their own “closings” and refinance prime loans at inflated rates, taking advantage of buyers’ financial illiteracy. “The American dream of homeownership is not realistic” for some people, Fox concludes. “Not everyone can or should own a home.”
Mortgage-backed securities: These securities are essentially bonds. Lending institutions and Wall Street investment houses, such as the quasi-governmental and now heavily subsidized Federal National Mortgage Association (Fannie Mae) and the defunct Bear Stearns, use investors’ capital to purchase mortgages from original lenders and issue “securities” that pay a return out of homebuyers’ pooled payments.
The online opinion journal Slate notes that “when the housing market is doing well and interest rates are low, investing in a mortgage-backed security is a fairly safe bet.” But as borrowers — primarily those of subprime loans — failed to make their mortgage payments and as housing values fell in parts of the United States where they had risen at exceptional rates earlier in the decade, cash flow dried up, investments began to fail and a whole lot of money went “poof.”
Housing bubble: Historically low interest rates encouraged an unprecedented demand among prospective homebuyers within the last three to five years, rapidly driving up home prices in such fast-growing parts of the country as Las Vegas, Phoenix and Orlando as well as much of California and the Northeast. Thanks to relaxed lending standards and intense market speculation, the process accelerated. This led to what is often referred to as the “housing bubble.”
Eventually, prices outstripped demand, and as buyers failed to make mortgage payments, home values in many of these areas came crashing back down. While much of the industrial Midwest missed out on the price boom that inflated the bubble, the damage to local economies and household finances was also severe.