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Underwriting Collapses

As they anxiously watched loan origination volumes top out, mortgage lenders searched for ways to keep the boom going. Adjustable-rate mortgage loans (ARMs) were a particularly attractive way to expand the number of potential home buyers. ARMs allowed for low monthly payments, at least for awhile.

Although borrowers have had access to such loans since the early 1980s, new versions of the ARM came with extraordinarily low initial rates, known as teasers. In most cases, the teaser rate was fixed for two years, after which it quickly adjusted higher, usually every six months, until it matched higher prevailing interest rates. Many of the homeowners who took on these exploding ARM loans were among the first to lose their homes in foreclosure.

Lenders also began to require smaller down payments. To allow home buyers to avoid paying mortgage insurance (generally required for large loans with low down payments), lenders counseled borrowers to take out second mortgages. For many such borrowers, the amount of the first and second mortgage together equaled the market value of the home, meaning there was no cushion in case that value declined. Moreover, although payments on the second mortgage may have been initially lower than the cost of the insurance, most loans also had adjustable rates, which moved higher as interest rates rose.

Such creative lending worked to support home sales for awhile, but it also further raised house prices. Rising prices together with higher interest rates (thanks to continued Fed tightening) undermined house affordability even more. Growing still more creative—or more desperate—lenders offered loans without requiring borrowers to prove they had sufficient income or savings to meet the payments. Such “stated income” loans had been available in the past, but only to a very few self-employed professionals. Now they went mainstream, picking up a new nickname among mortgage-industry insiders: liars’ loans.

By 2006, most subprime borrowers were taking out adjustable-rate loans carrying teaser rates that would reset in two years, potentially setting up the borrowers for a major payment shock. Most of those borrowers had put down little or no money of their own on their homes, meaning they had little to lose. Many had overstated their incomes on the loan documents, often with their lenders’ tacit approval. By any traditional standard, such lending would have been viewed as a prescription for financial disaster. But lenders argued that as long as house prices rose, homeowners could build enough home equity to refinance before disaster struck.

For their part, home appraisers were working to ensure that this came true. Typically, their appraisals were based on cursory drive-by inspections and comparisons with nearby homes that had recently been sold or refinanced—in some cases, homes they themselves had appraised. Lenders, meanwhile, were happy to see their subprime borrowers refinance; most subprime loans carried hefty penalties for paying off the mortgage early, and that meant more fee income for lenders.

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