To help companies keep pace with the rapid changes emerging from the crisis, Protiviti published a report, The Current Financial Crisis: Frequently Asked Questions, which answers more than 100 important questions about such emerging issues as mortgage loan modifications, the auto industry bailout, and the potential impact of the new administration on the current economic situation. The bulletin also includes updated information about issues addressed in prior editions as well as an expanded timeline of events.

 

SmartPros is pleased to partner with Protiviti to bring you our second installment of our series based on the questions in this report.

 

While there is not one standard definition, subprime borrowers typically are described as borrowers who have weakened credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgments and bankruptcies. These borrowers also may display reduced repayment capacity as measured by such considerations as lower credit scores or higher debt-to-income ratios.

 

Who are the major players in the subprime market?
It is the very complexity of the subprime market that has made resolving the problem so difficult. Apart from borrowers, the other major players in the process include:

 

The following chart depicts how all of the various players interact.

 

 

Why were financial institutions and rating agencies not able to forecast the performance of the loans?
Subprime loans originated between 2000 and 2005 did evidence a predictable pattern. Borrowers generally kept their loans current for one year or more after origination, so performance in the early years at least was considered low risk, especially when coupled with the view that even if there were a default, the collateral value would more than offset the loan balance. This all began to change in 2006, when anecdotal evidence now suggests that weaker borrowers began to enter the market in growing numbers at the same time that real estate prices started to decline.[i] From 2006 on, predicting the performance of subprime loans became much less reliable.

 

While subprime loan defaults continue to be the most serious single problem facing the loan market, delinquency rates are increasing substantially for nearly all credit classes, including ALT-A and jumbo (i.e., those with amounts greater than US$417,000) mortgages. For example, Fitch Ratings announced in December 2008 that delinquency rates for recent ALT-A originations had risen by as much as 585 basis points between May and October of 2008.[ii] One of the primary triggers for delinquency problems in the subprime market was the origination of loans that were unaffordable at inception (or that contained future payment reset provisions that should have been expected to become unaffordable). Conversely, problems in other credit classes increasingly are being caused by deteriorating employment market conditions (e.g., a borrower was able to repay the loan at inception, but is now unable to do so as a result of a lost job or reduction in salary), as well as continued declines in real estate values (e.g., a borrower is theoretically able to repay his or her loan, but allows the property to go into foreclosure because its value has declined to a level far below the outstanding loan balance).

 

What are ALT-A loans?  

An ALT-A loan is one made to a borrower who has generally good credit, but the terms of which do not meet conforming loan guidelines. For example, the loan might have been originated without fully verifying the borrower’s income or assets, have an interest-only or “payment option” feature that could result in no or negative amortization over some or all of the loan term, and/or have been made with no or little money down. As the market tended to place ALT-A loans in between prime and subprime loans in terms of perceived risk, these products were typically priced slightly higher than prime loans, but slightly lower than subprime ones.

 

A paper published by the Federal Reserve Bank of Dallas in November 2007 estimated that approximately 6 percent of all residential mortgage loans originated at that time fell into the ALT-A category,[iii] although this percentage has almost certainly fallen significantly since then as a result of the near disappearance of the secondary market for these types of products and limited appetite on the part of originators for carrying these loans on their books.

 

 

 

 

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[iii] http://www.dallasfed.org/research/eclett/2007/el0711.html.