How did the Subprime Industry Get So Big?
In 1994, subprime mortgages made up less than 5% of all mortgages, but by 2006 that number had increased to 20%. There are different theories on what made the industry grow so significantly, but most boil down to three key things.

1. After the stock market crash in 2001, the Federal Reserve Bank (or Fed) began dropping interest rates. Interest rates are basically the price you pay to borrow money, so they made borrowing very cheap. This meant that companies had ready access to cash to invest in new investment, products, factories, etc. By 2003, they had reduced interest rates to just 1%. This meant there was a lot more money in the economy to be invested.
2. Throughout the 1980’s there were a number of changes in banking regulations that made it possible for a wide array of institutions (hedge funds, investment banks, etc.) to issue mortgages. Additionally these changes made it much easier to loan money to people with bad credit. When successful, these types of loans could be very profitable because the interest rates charged could reach double digits. So there were more institutions able to issue mortgages, and more people who could now qualify to get them.
3. The housing market took off. With property values skyrocketing each year, people with heavy credit-card debts found themselves with a ready source of cash – home equity. Thus it was not uncommon to see homeowners refinancing multiple times. Similarly, after watching their neighbors houses significantly increase in value, people who couldn’t historically afford homes would take advantage of subprime mortgages to get in on the housing market.

So there was a lot of money to be invested, a lot of organizations looking to invest, and a lot of people happy to take on new loans. These things combined to make subprime mortgages accessible to many people who couldn’t have gotten them in the past. About half (44%) of the subprime mortgages were used to purchase homes (the rest were used to refinance existing mortgages). Historically, 64% of Americans owned their own home. In 2005, this number jumped to 69%, and most experts believe that this increase is due largely to subprime lending. The rest of the subprime borrowers were refinancing their homes to cash out equity, often to pay off higher-interest credit card debt.

Subprime Loans – the Downside
A subprime loan is a risky proposition under any circumstances. However it’s less risky when the housing market is booming. Many subprime loans start out with a low or even 0 interest rate for the first few years which then typically jumps up to 10% or more after the initial period. If your house is increasing in value 15% a year you can always refinance when the initial period is over, using the equity in your house to cover any prepayment penalties that may be associated with your mortgage. However if your house isn’t increasing in value or worse, is decreasing in value, you can’t refinance and are now stuck with mortgage payment that could be double what you used to pay. Unable to refinance or afford your mortgage payment, you’re forced into foreclosure where you lose your home, plus any equity you might have in it, and you get a big black mark on your credit report that is going to make it difficult for you to get credit in the future.

And that’s exactly what is happening to the market now. A recent study by the Center for Responsible Lending suggests that almost 20% of subprime loans issued in 2005-2006 will go into foreclosure. This could impact as many as 2 million homeowners. Although these foreclosures can impact cities all across the country, those hardest hit tend to be cities which have had economic troubles (factories closing, higher numbers of people laid off, etc.) such as Philadelphia, Detroit, Baltimore, etc. and cities with especially hot housing markets like Las Vegas, Phoenix, San Francisco, etc. As these homes go into foreclosure, the number of houses for sale in the market increases. This increase of supply can further decrease home prices in the area. In an effort to curb the number of subprime mortgages, the government is creating regulations which will make it more difficult for the highest-risk people to qualify for them. In the long term, these changes will help to reduce the foreclosure rate by helping to ensure that people qualifying for homes can actually afford to keep them. In the short term however, people who were counting on refinancing to get out of an existing subprime loan may find it more difficult to do so, thus leading to even more foreclosures.

Although steps to modify the nature of subprime loans, such as removing the refinancing penalties and requiring lenders to be more realistic about who they issue loans to, will help, the sheer number of outstanding subprime loans will likely be a drain on the housing market for the next few years. The growing number of foreclosures will hurt housing prices in areas where subprime loans are most common. And tighter lending standards will lead to fewer homebuyers in the market. Hopefully with time, these modifications to the subprime mortgage industry will help it to return to what it once was, a mechanism to help higher risk people buy homes they can afford to keep.

Additional Resources:

The Buzz about Subprime Loans - Part I

Mortgage Professor

Wikipedia

US Dept. of Housing