Why Are Investment Companies Buying Subprime Mortgage Bonds Again?

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After the financial crash of 10 years ago, subprime mortgage bond issuance has been rare. It was those risky securities that effectively brought the US economy and world economy to its knees. But recent information from the financial industry suggests investors are buying subprime mortgage bonds again.

According to the Financial Times, subprime mortgage bond issuance rose in the first quarter of 2018. It went from $666 million to $1.3 billion. The publication also quoted a financial analyst who thinks issuance for all of 2018 will hit $10 billion. This is more than double the $4 billion issued in 2017. This represents a big increase, but for comparison’s sake, the value of American subprime mortgage bonds in 2007 was $1.3 trillion.

Since the last financial crisis, mortgage backed securities have been mostly issued by Freddie Mac, Fannie Mae, and Ginny Mae. After the collapse, these organizations have refused to insure subprime loans. The Dodd-Frank regulations that passed after the crash put tighter rules on subprime lending that mostly killed the practice.

But since 2016, specialty finance companies have gotten back into the subprime market. Subprime has been re-branded as non-prime. Investors who want bonds that feature higher yields have created enough demand for these loans to be securitized. This is exactly what happened in the run up to the crash. The result we see is an expanding subprime mortgage bond market.

Experts in the mortgage industry say that the appetite of loan originators to work in the subprime space is growing as it is an opportunity to make more money. Loan officers are again learning about what subprime loan programs are available. If realtors and borrowers become more aware of the subprime lending possibilities today, it is possible the practice could spread. It’s no secret that consumers still need non-qualified loans as many people do not meet the requirements for traditional mortgages.

More lenders may be tempted to get into the subprime market, which features loans that cannot be bought by Fannie and Freddie. They may be looking to increase their income that is being lost from mortgage refinancing, as rates have been climbing higher. Some of these lenders argue that current subprime loans are safer than the ones that rocked the financial system 10 years ago. For example, sponsors of the riskier mortgage backed securities must keep at least 5% interest in the loans offered. Since 2014, all mortgage lenders in the US must show that they have checked the ability of the borrower to repay the loan.

Some say it seems strange that subprime mortgages are getting back into the US market. The slow pace of homes being built and fewer homes available for sale is causing a dearth of inventory in many areas. The lack of supply has caused home prices to rise out of the reach of many in the middle class in some areas of the US.

This has caused somewhat of a seller’s market. Competition is intense for the available properties. Moderately prices houses can get bid up to the point where they are unaffordable for regular people. Expansion of credit into the subprime space is not going to reduce the problem of the housing shortage. It will only make it worse as it will add to the numbers of people who are wanting to buy a home. This will increase demand and will push prices higher, and this can make lending in the subprime market even more risky.

Some say that it is alarming that Wall Street is flirting with the same habits of 10 years ago that rocked the financial markets and led to the most serious downturn since the Great Depression.

In March 2018, Congress was looking at a bill that would actually roll back some of the Dodd-Frank rules that tried to limit risky lending practices and limited the effects of huge banks that were too big to fail. It is possible that now that the omnibus budget has been passed, Congress will again be looking at repealing Dodd-Frank, which could heat up the subprime market even further.

The bottom line is that mortgage backed securities  based upon subprime bonds are starting to get popular again. As usual, the basic motivation is money. Lenders want to make more money and are dipping their toes back in these dangerous waters. How much this practice will spread remains to be seen.

References: https://www.curbed.com/2018/3/30/17179750/subprime-mortgage-bonds-comeback