To many the situation surrounding subprime loans is seen as a major economic crisis that threatens the stability of our nation's housing market.
But to others those critics are viewed as people akin to "Chicken Little," creating a major catastrophe out of what in reality is a much less significant event.
Though some subprime borrowers have found themselves in difficult financial straits of late, many borrowers used the product to their advantage, going on to refinance to traditional 30-year fixed-rate loans.
In Utah, homeowners such as Karen Peavler of Roy are continuing to live the American dream of homeownership thanks to a subprime loan.
In 2006, the 42-year-old Peavler, a Realtor herself, was considering ways to manage her debt. But she didn't qualify for a conventional mortgage at the time.
She'd purchased her home in 1997 and, after remodeling last year, she decided to refinance her home using a subprime loan with a fixed two-year interest rate. She says it made the most sense for her circumstance because it would allow her to pay off her bills and get her finances back in order.
"In my opinion, that's what the loans are designed for. To allow people to square off their finances and move on to a traditional means of financing," Peavler said.
Peavler, who currently shares her home with two of her three children and two grandchildren, says she expects to refinance again when her fixed period ends in December 2008. By then Peavler says her bills will be paid off and she will be in a better financial position. For her, using a subprime loan has given her the opportunity to maintain her homeownership, something she's grateful for.
"Subprime mortgages are designed for those people who have credit scores below 620," explains Matthew Prestwich of National Mortgage Brokers in Murray, who handled Peavler's subprime refinance.
He said these loans are typically amortized over 30 years, but the initial rate or start rate is only fixed for two or sometimes three years after which time the rate adjusts to a (usually) much higher variable rate. Such types of loans are designed to force the borrower to refinance at the end of the two- or three-year fixed-rate period.
"It is in the best interest of the investors who provide the money for these loans to turn their loan portfolios over every two or three years. In the last few years investors have loved these loans," Prestwich said.
Investors loved the loans because they were able to profit using a three-tier or tranche system that allowed them to make money based on the amount of risk the investors were willing to take. The top tier bore the least risk, with the bottom tier taking the highest risk. Such risk-taking could be especially profitable with some garnering interest between 15- and 20-percent returns. The problem came when Wall Street banks became very nervous after seeing higher than usual subprime default rates, prompting what Prestwich considers an "overreaction," and he says the subprime lending crisis is overblown.
On his blog he writes, "In typical Wall Street fashion, investors are having a knee-jerk response. Like what happens every time the markets behave irrationally, I think some large, smart investor will come in and buy these obligations for a song from investors who will be all too willing to sell at a discount. This investor will then proceed to make a killing on the performing portions of these portfolios."
As most economists will tell you, the lending business depends upon borrowers defaulting at rates that are reasonably predictable. When default rates spike, it throws the entire industry into a state of unrest.
That unrest has forced the closing of numerous major wholesale mortgage lenders such as New Century and American Home Mortgage. New Century used their large lines of credit obtained through commercial and Wall Street banks to underwrite loans to borrowers nationwide. Generally, about 20 percent of all mortgage loans are so-called subprime loans with around 20 percent of those loans becoming delinquent — meaning only about four percent of the total number of loans are past-due subprime loan. And the percentage of loans that actually go into foreclosure is typically even smaller, but the current situation is not typical.
Foreclosure rates have jumped significantly in many states as banks forced lenders such as New Century to buy back all of their outstanding loans. Lenders such as New Century or Aegis wouldn't have the cash necessary to purchase all of the loans back and therefore have been forced out of business.
Some critics consider the response by banks irrational and overblown because it essentially created a major crisis when a more measured response could have limited the overall economic fallout. Had the banks moved forward, allowing for a higher-than-normal rate of foreclosures and recovered part of their losses through sale, the overall impact would have been much less.
Prestwich cites possible conflict of interest as one of the reasons big banks found themselves backing so many higher risk loans. He says in an effort to get the best possible rating for their investments, the banks hired services such as Moody's to audit their loan files and were able to obtain the coveted AAA rating for them. He does not suggest any wrongdoing but thinks the relationship may have resulted in questionable judgement on both sides.
Since the so-called crisis began, dozens of wholesale lenders have closed their doors, resulting in thousands of employee layoffs in the mortgage industry. Prestwich believes this latest situation will force the entire mortgage lending industry to completely re-evaluate itself, resulting in better loan programs and improved lending standards.
Even with the increased number of problem subprime loans, he thinks the positive outcomes far outweighed the negative. He says 80 percent of people who took out subprime loans were able to get into homes they otherwise wouldn't have been able to purchase and have done so successfully.
Despite Peavier's positive experience her twelve years as a realtor has taught her a few lessons about potential borrowers. She believes part of the problem with so many people defaulting recently has to do more with borrowers poor credit and money management, then choosing loans they can't handle.