Why a Lender Takes a Risk, Especially on Subprime Mortgages

The mortgage industry and particularly the lenders of subprime mortgages have taken a beating in 2007. The subprime mortgage market has suffered substantial losses, especially in summer of 2007, as acknowledged by the Fed Chairman Ben Bernanke at the Economic Symposium on August 31.

Bernanke observed: "With securitization impaired, some major lenders have announced the cancellation of their adjustable-rate subprime lending programs. A number of others that specialize in nontraditional mortgages have been forced by funding pressures to scale back or close down."

What this means is that people who want to buy a home with less than stellar credit have to look harder for a home loan. There are not as many subprime loan products available during the housing market slump. Whether they try going through lenders or mortgage brokers, homebuyers are getting frustrated with the troubled market.

This blog entry helps consumers to understand why it is risky for lenders, but especially subprime mortgage lenders, to finance home loans.

Consumers should understand that lenders are in the business to make money. They are seeking buyers of their loan products while homebuyers are shopping around for a loan. Whether the homebuyer is using a lender directly or utilizing a mortgage broker, the lender is still the provider of the loan.

A study by the Georgetown University Credit Research Center (CRC) in June 2006 notes that lenders face uncertainty about whether homebuyers who are receiving their marketing promotions will actually purchase their loan products. Referring to a 1994 work by Yavas, the CRC study further reports: "Moreover, when the [reservation or desired] price involves borrowers' uncertain promises to make future payments, borrowers must demonstrate their creditworthiness, and lenders perform credit evaluations to avoid unacceptably risky promises." The study notes that a mortgage broker might be the party that successfully matches the buyer with the lender.

So how does the lender make money when it is taking a higher financial risk on subprime mortgages? The CRC study explains: "Matching on the basis of creditworthiness is likely to be especially important in subprime mortgage lending, where the pricing of products is explicitly tied to creditworthiness." Essentially, the loan interest rate will be higher for people with shakier credit.

Recent media stories have voiced much criticism of subprime lenders for having prepayment penalties and highly inflatable interest rates. These lenders are "hurting" consumers. The subprime market, instead of the global financial market, is getting blamed for people losing their homes. The other side of this issue is that homebuyers were happy to obtain loans from subprime lenders when the economy was good. Why do they blame lenders when the economy takes a dive?

Understanding how the economy really works is no easy task. It is just wise to get the facts about the subprime market and how mortgage lending works before assuming that all subprime mortgage programs are bad. A great book to read for understanding the economy is "Businomics" by Dr. William Conerly, a leading economist. Try to understand your economy when it is plunging into recession, and profit from that knowledge when the economy bounces back.

References:

"The Pricing of Subprime Mortgages By Mortgage Brokers and Lenders," June 2006, Georgetown University Credit Research Center, Available at: http://www.namb.org/namb/Home_Buyers_Home.asp?SnID=1342891129