Subprime Mortgages

The Subprime mortgage market is imploding. Just checkout mortgageimplode.com.
What does that mean to the average Joe? Not much
The mortgage industry is one of the most regulated industries in the US with regard to disclosures to their customers. Borrowers must receive a Truth-in-Lending (TIL) statement and Good Faith Estimate (GFE) of charges within 72 hours of application. The TIL states what the Annual Percentage Rate (APR) is. Generally speaking, the lower the APR the better the loan. The GFE details the charges that will be incurred because of the loan. Any charges that are paid to the Lender for non-descript fees (aka Junk Fees) are included in the APR and those that are paid directly to a third party (aka Appraisal & Credit Report) are not.
Subprime simply means that the borrowers don't qualify for the best loan terms. They have credit issues, bankruptcies, foreclosures, etc in their past. To make up for the added risk Lenders charge more fees and/or a higher interest rate.
Everything so far is above-board and the risk to the investor who buys the mortgage from the Lender is fairly easy to calculate.
With the growth of the Subprime market came the advent of new products. Chief among them were the Interest Only and the Pay-Option Arm programs.
Both programs are Adjustable Rate (ARM) programs where your interest rate is reset at set intervals based on an index such as the 1 yr Treasury Rate. Hence, interest rates go up, so will your mortgage payment.
The Interest Only is just as it implies. It's usually something like 10 yrs of paying only the interest portion of the loan and the other 20 years paying down the principal and interest. This allows the borrower to get the interest & tax payment incentives and also, hopefully, getting appreciation on their property value over ten years which gives them a REAL stake in the property.
The Pay Option ARM is a completely different animal entirely. It allows the borrower to pay the fully amortized payment which reduces the principal balance with each payment, or they can pay just the interest, or they can pay a reduced payment which actually INCREASES their principal loan balance. This is called Negative Amortization.
Another aspect of the Subprime market was that they were allowing higher and higher Loan-to-Value (LTV) loans. For instance, if someone was buying a $200,000 home they could get a loan for $200,000 and they would only have to pay closing costs. That's considers a 100% LTV.
The Risk with high LTV loans is that the Borrower could walk away from the property with little skin in the game.
So how did we get to where we are now? It's a common element of all capitalist societies, it's called Greed. Borrower's want the benefits of homeownership even though they don't really qualify, and investors in those mortgages want the higher returns even though they know there is significantly higher risk.
It's definitely not the worst-case-scenario but what happened was that there was an increase in interest rates, a stagnation in home prices, and also stagnation in wages. After a year people's home payments went up but their pay didn't. Their properties also didn't increase in value. If they had a Pay Option they might have opted for the lowest payment possible which increased the Principal Balance on their loans. If they still couldn't pay after their payments went up with the interest rate increase then their lenders foreclosed on a loan that may have been more than the property value. Obviously a lose-lose for everyone involved.
The Borrower has a lot to lose but ultimately the investor loses the most because they bought loans that are non-performing and have assets (the property) that don't come close to covering the costs of forclosure through selling of that property.
What happens is what we are seeing now. The investors don't want to buy any more of those loans so the whole subprime market is drying up.
People always try to assign blame but in this case I don't think that there is any. Ultimately the people that suffer are the Borrower who was trying to get the American Dream even though they were marginal, at best, and the Investors in those loans who wrote the guidelines and are going to take the financial burden of the defaults that happen.