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Subprime mortgage debacle

The subprime mortgage debacle refers to the credit crisis of 2008. In an effort to encourage making loans available to a broad spectrum of applicants including those with less that prime credit histories, the Federal government encouraged subprime loans, which resulted in non-performing mortgages when housing values stopped climbing and began to decline.

Expanded Definition

A combination of circumstances made the situation worse. Lenders were able to bundle and resell the mortgages promptly. That reduced the risk that they would get caught with bad mortgages. As a result they began to focus on profits from the fees for loan origination. Many loans were issued based on the borrower's claimed income and assets without requiring documentation. The normal due diligence was absent or inadequate in part because borrowers could usually be bailed out by refinancing against the equity generated by rapidly rising home prices.

Adjustable rate mortgages (ARMs) became popular to qualify additional borrowers whose income would not otherwise have qualified them for the loan. Many had teaser interest rates that were well below market. But when interest rates reset to market rates, the borrower was forced to refinance creating another loan application and additional lucrative loan origination fees. When housing prices began to decline, many could not make payments, had no equity on which to refinance (or qualify for lower interest rates), and were forced into foreclosure.

The mortgages were packaged into bundles and sold widely to institutional investors and even to individuals. The bond rating agencies rated these bundles AAA based on a history of few defaults while housing prices were rising and the experience that housing declines were usually regional allowing bundled securities (and derivatives based on them) to perform consistently. None of the agencies involved seemed to conduct adequate due diligence. All were surprised to learn of poor documentation of the loans or of the risks posed by a broader decline in housing values.

As a result various institutions find themselves holding large numbers of mortgage backed securities that are non-performing. They are probably not worthless, but they are underwater in that the current market value of the property is less than the amount loaned on the property. Many are abandoned by their owners or foreclosed with the result that lender now must pay property taxes, insurance, maintenance, utilities and management costs. Not only does the lender not receive interest on the loan, but the loan produces negative cash flow from those charges plus legal expenses. The securities are said to be marketable, but at a significant haircut, i.e., discount from face value.

Investors who bought the securities and dealers who handled them find their assets encumbered by these bad mortgages, often called toxic paper. Those that are publically traded are supposed to write down their assets to the lower of cost or market. That means they should mark to market. But to do so, would wipe out much of their asset base. Those that rely on borrowed capital and their bond rating to allow borrowing at favorable interest rates are unwilling to take the large write downs required. Instead they prefer to retain the assets on the books in hopes that housing prices will recover or some bailout will emerge. As a result their capital position is impaired. They are unable to make loans and lack capital to engage in their usual finance activities. This limits availability of capital to the commercial markets and restricts economic activity due to lack of money supply.

A series of individual government backed bailouts have already been arranged. Bear Stearns, American International Group (AIG), Fannie Mae (Federal National Mortgage Association or FNMA), Freddie Mac (Federal Home Loan Mortgage Corporation or FHLMC), Washington Mutual, and Wachovia have been completed. A proposal is pending in Congress to allow the federal goverment to buy defaulted mortgages. The intent is to provide liquidity for commercial financial activities.

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