U.S. Federal Reserve Governor Susan Bies has said she anticipates an even higher level of mortgage default rates in the coming months on loans made to high-risk borrowers. Economists explain what's behind the trend and discuss the consequences.
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As the housing slump continues, lenders, borrowers and investors are coping with a new worry: rising mortgage defaults, especially among high-risk homebuyers with poor credit history or heavy debt.
Many of them were able to qualify for a mortgage financing in the first place only by obtaining what are known as "subprime loans." Here's how it works.
A homebuyer receives a loan from a subprime mortgage lender and makes payments to that lender. The lender then arranges the mortgage and, in most cases, sells it to a commercial bank or Wall Street firm. Those companies then repackage the loan with mortgage-backed securities and sell them to investors.
The tradeoff for borrowers: interest rates often 2 to 3 percentage points higher than regular mortgages. But getting the loan is easier, with low initial "teaser" rates that adjust upward over time.
As the rates rise, the loans get tougher to repay. And when homebuyers default on these loans, the original lender has to buy back the loan from the banks and Wall Street firms.
That cycle has been exacerbated in the last few months by generally rising interest rates and falling home prices that have depressed the once-booming housing market. Last year alone, subprime loans accounted for one out of every five new mortgages.
More than two dozen subprime lenders have been forced to close or sell operations. The latest casualty: New Century Financial Corporation, the nation's second-biggest subprime mortgage lender.
New Century stopped accepting new loan applications last week and announced today that all of the lenders that have been keeping them afloat have now cut off their financing. That could push the company closer to bankruptcy.