I read an article at least once a day the puts the blame for the mortgage mess on lenders who made loans to people with bad credit histories. Although this did happen and there was some fraud involved, it is only part of the issue with the sub-prime problem.



Sub-Prime loans are defined as loans that are non-conforming to the Fannie Mae or Freddie Mac resale markets. These federally backed, publicly traded companies were developed to allow the mortgage markets to maintain the liquidity they need to continue to write mortgage loans in the US.

These conforming loans are packaged and sold on the market as mortgage backed securities and are supported by the US government. Each loan in the package must meet strict guidelines in order for it to be sold. Every loan needs to have documentation as to employment, income and the loans cannot be over $417,000. Most of these loans also require a credit score of at least 580 and between 10-20% equity.

This leads to the logic question of why loan money to people who do not have equity, or high credit scores or can prove that they make enough money to pay the loan back? The answer becomes a little more clear when you see where the real estate troubles are the clearest. The states of Florida, California, and Nevada are currently the hardest hit by the current bust. Ohio and Michigan are also among the list but their issues are more based on job losses in the area than any market based problems.

Florida, California and Nevada have problems that are pretty unique unto themselves. First all three states have high median home prices, in California it is $514,000, In Florida it is $259,000 and in Nevada it is $478,000. The median price is the exact middle of the range. This means that there were as many homes over that price as there were under that price. So as you can see clearly over half of the homes in California and Nevada are considered non-conforming simply because they are over the Fannie Mae limit.

What it all means

What all of this means is that not all sub-prime loans are bad. Sub-prime loans were being made to self employed people with good credit, who had a hard time showing enough income to qualify for a conforming loan because of personal guarantees they may have had to make for their business loans. Sub-Prime loans were made to clearly ½ of every home in California and Nevada simply because they were over the maximum conforming limit. They were also made to people who had credit scores slightly under the minimums needed to qualify for a Fannie Mae product. Things such as having a credit balance too close to your limit on one card can lower your score by as much as 30 points.

These loans are not what most people think of went they hear sub-prime lending. But with the media miss-stating the issue, banks and the market have effectively shut off the money available for these types of loans. If a borrower that fell into one of these categories were lucky enough to find a sub-prime product today, they would be paying anywhere from 1% to 1.5% more for their loan then they would have a year ago.

This lack of availability to sub-prime funding is fueling the downward slide in values in these three big markets. If the funds are not available to borrow and the cost of borrowing has increased by more then a percent over the last year, it is going to have a negative effect on value. On a $500,000 home that could be a $416.00 a month difference. The effect that has on the buying power of that person is about $100,000. Meaning that if the borrower has to pay 7% on a loan instead of a market price of 6% then they can effectively afford a home of $400,000. This cost and availability of money is one other reason home prices are falling.