With mortgage loans, as with any other complex subject, it’s a good idea to understand the basics, including the terminology.  Without a clear, uniform definition of sub-prime mortgages it’s difficult to know exactly what role these loans, and the securities, “swaps” and other derivatives based on these loans have played in our current credit crisis.  So, with over 20 years in the business and my own firm, I guess I’m as qualified as anyone to explain the various types of mortgage loans, how they differ, and how this mess came about.  Certainly there is more than enough misinformation floating about, from both sides of the aisle

There are basically three categories of mortgage loans: government loans, of which the vast majority are FHA, but also including VA and some Rural Development Authority mortgages; so-called “conventional” or conventional conforming loans, those eligible to be purchased by Fannie Mae and Freddie Mac; and finally non-conventional or “sub-prime” mortgage loans

(For purposes of this discussion, we can ignore the entire category of government loans.  They are explicitly guaranteed by the federal government, as are the bonds that are issued by the Government National Mortgage Association, called Ginnie Maes which are backed by those mortgages.)

Within the two categories, conventional and non-conventional (or sub-prime) there are a broad array of mortgage products available:  15-, 20-, 25-, 30-, and even 40 year fixed rate loans, as well as an assortment of adjustable rate mortgages with a variety of indexes, margins, and adjustment periods.  On the non-conventional (sub-prime) side, there are/were also some loans available with varying payment options, including fully amortizing payments, interest-only payments, and even some with a so-called “minimal payment option” which did not even cover the current month’s accrued interest which, along with the principal portion of the payment, was added back onto the balance due on the mortgage, so that the mortgage balance actually grew over time, though hopefully not as fast as the property was appreciating in value

A non-conventional/non-conforming/sub-prime mortgage is one that does not meet the conventional, or conforming underwriting guidelines issued by Fannie Mae and/or Freddie Mac.  Neither of the GSE’s will purchase this loan.  However, other institutions in the private sector will

(It’s worth noting that a number of apologists for CRA and the effects that legislation has had on the mortgage market, including the Traiger-Hinckley, LLP study referred to here earlier, have taken to using the term “high cost loan” interchangeably with “sub-prime.” This is decidedly dishonest.  A “high cost loan” has a very specific definition, detailed in Section 32 of Regulation “Z” of the Home Ownership and Equity Protection Act of 1994 (HOEPA), which itself is an amendment to the original Truth In Lending Act.  While all Section 32 “high cost loans” are sub-prime, only a small portion of sub-prime loans qualify as “high cost loans.”)

A number of factors can enter into the decision to take a loan application the non-conforming or sub-prime route: a credit score lower than the minimum necessary to qualify for a Fannie/Freddie conventional loan is certainly the most common.  But other factors such as non-verifiable or unusual income sources, high debt-to-income ratios, or a recent major career change, can all enter into an underwriter’s decision.  There are also so-called “jumbo” loans, which are above the upper limit for conventional conforming mortgages and would thus not be eligible to be purchased by Fannie or Freddie

Some examples:  An electrician, a website designer, a graphics artist, a marketing consultant, a technical writer, and a home improvement contractor all have one thing in common – they’re in business for themselves.  And if they are like the hundreds of other self-employed individuals I’ve known over the years, they all under-report their income in one manner or another.  Some such under-reporting is patently illegal, while some of it is perfectly legal, such as the car payment, insurance payment and gas credit card that are paid for out of the business account instead a personal account… even though those accounts are undoubtedly listed on the individual’s personal credit report and thus must be included in his/her individual debt-to-income calculation

Similarly, an example of an unusual or unverifiable income source would be someone who makes his living by trading stocks, commodities, options, or futures.  Another would be an individual who just recently went into business for himself and thus did not have the two year minimum track history and tax returns required for a self-employed individual.  There are also some people who simply prefer a non-conventional/sub-prime mortgage rather than having to reveal their personal and business tax returns, as would be required by conventional underwriting

Still, the vast majority of non-conventional/non-conforming/sub-prime mortgages are given to those whose credit history and scores are not good enough to qualify for a conventional Fannie/Freddie mortgage loan

Non-conventional/sub-prime mortgages are/were a greater risk to an investor, so naturally the rate is higher and the terms more onerous to offset that higher risk.  Just like a person who smokes or has a family history of heart disease is going to be charged higher life and health insurance rates, or the driver with several moving violations and a couple DUIs who pays a higher automobile insurance premium.  After all, why should the man with a 780 FICO score who is scrupulous about his finances, pay the same rate as someone who has a history of abusing credit and ignoring his obligations?

Just as conventional loans are purchased from banks, brokers, and mortgage companies by Fannie and Freddie, then bundled and “securitized”, so too most sub-prime loans are/were sold off and securitized.  The purpose in both cases is to provide a steady stream of liquidity, so that there is always money available for those who want to buy or mortgage their home.  Without that secondary market, that is, if banks and mortgage companies held all the loans they made in their own portfolio instead of selling them, there would soon be no mortgage money available for the next | save this article / add to your favorites list