In order to stabilize the mortgage lending industry, different lending programs have been introduced with most being adapted even today, specifically (1) Adjustable-Rate Mortgages (ARMs), (2) Mortgage-Backed Securities (MBS) and (3) the most controversial – Subprime mortgage loan. According to Wolfson (1994), AMRs increase the sensitivity of mortgage assets to changes in interest rates (100). AMR mortgage loan is almost similar to the standard CPM except that the interest rate depends on variety of indices (e.g. 1-year constant-maturity treasury securities, cost of fund index, etc. ).
The principal purpose of the indices is to avoid the negative impacts of economic variations (e. g. inflation changes, housing value changes, etc. ) towards the lender. However, the disadvantage of AMRs is that some borrowers cannot cope up with the changes of interest rates, especially if the trends direct interest rates upward.
Meanwhile, MBS imposes a different system wherein the principal balance and advance interest payment serve as the support for possible economic variations. According to Wolfson (1994), MBS are more liquid than mortgage loans, and thrifts can use them as collateral for borrowing; although, MBSs do not actually improve the interest sensitivity of thrift’s mortgage assets.
However, the problem with these programs and other mortgage loans is that only the specific population (families with income relatively above poverty lines) avail their mortgage lending service. Thus, in order to resolve the issue, the subprime mortgage loans have been introduced to the public in aims of supporting those low-income and high-risk borrowers provided that higher interest rates shall be placed depending on the terms and program policy (Fabozzi 22).
However, like other previous mortgage loan programs, subprime mortgage lending is also facing a direct crisis due to the compromised housing values that complicated the refinancing of mortgage loans. Real Estate Market Booming Leading to the Subprime Crisis Like most investment commodities, the latest real estate booming has been associated (1) to the decrease in the interest rates, (2) low cost of principal investments, and (3) relative amortization rates.
According to Hill (2008), the latest real estate booming or housing bubble or that occurred in United States, specifically in 2006, have caused tremendous crisis in the lenders of the 2005 (51). According to the United Nations Department of Economic and Social Affairs (UNDESA 2007), the slowdown in the trend of various measures of the housing sector in the United States has accelerated during the course of 2006 despite of the month-to-month variation of house price indicators (e. g. interest rates, employment rates, etc.).
The decline of the real estate prices has caused intense impact to the market due to the high price differentiations compared from the price index of the previous year. According to Hill (2008), the decrease of real estate prices has originated in the economic bubble burst in stock market during 2000. Eventually, the price indices of most countries, specifically the United States, peaked to 12. 5 in 2005 from 8. 4 in 2004; however, around to 2006, the price index in United States has declined down to 9. 1 (22).
As supported by UNDESA, the new home sales of United States’ real estates, specifically in areas of California, Florida, New York, Michigan, the Bo Wash megalopolis, and the Southwest markets, have been under consecutive and fixed steady rise for several years but declined by about 20% in 2006 compared from the level in 2005 (16). The housing bloom has caused the immediate and direct strike to various financing groups, such as mortgage, credit loans, foreign banks and most especially, subprime mortgages.
According to UNDESA, home sales have also dropped and all other housing market indicators (e.g. interest rates, amortization fees, principal payment, etc. ) show a clear slowdown (16). In the records of the price index decline among Subprime firms, approximately 20% has declined to the overall receivables of the firm. According to Ferguson, Hartmann and Panetta et al. (2008), the intense decline on house values in 2006 and the late payments starting in the last quarter of the same year actually triggered the closure and bankruptcy of some of the main subprime operator and currently raising several issues of systemic relevance (83).
Subprime mortgage companies are now at the verge of progressing decline and the difficulty of refinancing the losses due to the great price decline is placing the industry under a critical crisis. From the projections of UNDESA, the further weakening of the housing sector is expected for the United States, and such unexpected repetition of housing price decline has triggered the piling of subprime negative equity mortgage. The lowest price decline in 2006 has been the scales of July 2006, which is also comparable to the decline records of April 2003 (17).