A really interesting
PDF about the origins of a bunch of this recent craziness. Focuses on what exactly is different about subprime mortgages.
First, when you hear subprime, think "Someone who declared bankruptcy a few years ago and has no money in the bank." I was thinking "someone with a bad credit score", but it's on average a good amount worse.
So the main thing is it's not like banks just gave subprime borrowers the same sort of loan they normally give. The simplistic talk-radio description is "they started giving loans to more people and they couldn't pay and it all blew up."
The question was, how exactly can you loan money to people with no credit or collateral. The general strategy is, give them a good rate for the first few years, then the interest rate becomes variable (which usually means it's a lot more.)
E.g. a 3/27 ARM might be, it's 8.5% interest for the first three years, then for the next 27 it floats at perfect-credit-rate plus 6.1%. Perfect-credit-rate is say 5.4%. So after the "jump" you're paying 11.5%.
This sucks, it's kind of like those cable deals where it's $20 a month for the first 6 months and then jumps up to $100 a month. But those make sense as an advertising ploy. They get you in, then you have kinda forgotten. But the problem with a mortgage is *can* you pay, not have you forgotten how much your cable bill is.
So the trick is, once you have spent a few years paying off the "good" rate on your subprime mortgage, then you have some equity built up in your house. Since you have some equity, you're a better credit risk now, and you can refinance at a better rate.
Everything would be just peachy if housing prices were fixed. The problem ends up being, if housing prices crash, then you can be underwater on your mortgage. Your first three years of payments don't make up for the net drop in house value. For a normal mortgage this doesn't really matter - you aren't selling your house after 3 years, so it doesn't really matter what the alleged "market value" would be. But it prevents you from refinancing, so if you were counting on that, you're screwed.
Why exactly does equity in your house make you a better credit risk? Well, if you are financially screwed in some way, you have a worst-case option of selling the house, paying off the (large) fraction that you still owe, and you still have some money in your hand. In practice you might refinance in some way that would give you some money but then you would have more on your mortgage to pay off. If house prices are fairly close (or higher) compared to when you bought in, the refinancing gives you some flexibility. Money paid off on your mortgage is closer to cash in the bank.
A final note - currently, about 1 in 6 mortgages are over 60 days delinquent.
