Jelis
VIB
Student loans now total over $1 trillion and delinquency rates are rising. Many young people are burdened in their 20s with tens of thousands of dollars of student debt. Some commentators have pointed to student loans as the next subprime. What does this mean? Does it mean that student loan defaults are expected to cause another financial debacle at some time in the future? Or does it simply mean that many people are likely to wind up worse off after taking out student loans? To evaluate these possibilities, it is useful to review the subprime story.
The subprime mortgage market is credited with playing a significant role in the housing boom and bust that precipitated the financial crisis and great recession. In the case of subprime mortgages, the idea was to expand home ownership opportunities to an underserved market; namely, people with poor credit scores, who are disproportionately minorities. Both public policy and private sector initiatives pushed forward the development of the subprime market. The basic premise was that traditional mortgage underwriting standards were too conservative. The evidence for this was that credit loss rates for prime mortgage loans were miniscule, just a few basis points a year.
Subprime mortgage loans generally refer to borrowers with low credit scores, like FICO score less than 620. The traditional approach to these loans was to require strong compensating factors such as very large down payments. Thus, the traditional approach to subprime did not entail weakening of underwriting standards. However, this changed in the 1990s and early 2000s. Government programs sponsored by FHA or by Freddie Mac and Fannie Mae included loans with both modest down payments and low FICO scores. Innovations in private label securitization (that is, in which no government or quasi-government guarantee is involved) appeared at first to be highly successful. Securities based on subprime loans received high ratings from ratings agencies like Standard and Poors and Moodys Investor Services and the demand for these securities was very strong. This enabled massive expansion of the subprime market until by 2005 it constituted 20% of all loan originations.
However, subprime borrowers were inherently more financially fragile. The viability of the market depended on the ability of the subprime borrower to upgrade to prime if a series of on-time payments was achieved. So long as housing prices continued to rise, the promise of upgrading to prime stayed intact. But when home prices peaked out in 2006 and began to fall the path out of subprime (and high mortgage rates) was blocked. This meant that subprime defaults were bound to soar. Combining this with early payment defaults by speculators, the value of mortgage backed securities declined sharply and set in motion the financial crisis.
The subprime mortgage market is credited with playing a significant role in the housing boom and bust that precipitated the financial crisis and great recession. In the case of subprime mortgages, the idea was to expand home ownership opportunities to an underserved market; namely, people with poor credit scores, who are disproportionately minorities. Both public policy and private sector initiatives pushed forward the development of the subprime market. The basic premise was that traditional mortgage underwriting standards were too conservative. The evidence for this was that credit loss rates for prime mortgage loans were miniscule, just a few basis points a year.
Subprime mortgage loans generally refer to borrowers with low credit scores, like FICO score less than 620. The traditional approach to these loans was to require strong compensating factors such as very large down payments. Thus, the traditional approach to subprime did not entail weakening of underwriting standards. However, this changed in the 1990s and early 2000s. Government programs sponsored by FHA or by Freddie Mac and Fannie Mae included loans with both modest down payments and low FICO scores. Innovations in private label securitization (that is, in which no government or quasi-government guarantee is involved) appeared at first to be highly successful. Securities based on subprime loans received high ratings from ratings agencies like Standard and Poors and Moodys Investor Services and the demand for these securities was very strong. This enabled massive expansion of the subprime market until by 2005 it constituted 20% of all loan originations.
However, subprime borrowers were inherently more financially fragile. The viability of the market depended on the ability of the subprime borrower to upgrade to prime if a series of on-time payments was achieved. So long as housing prices continued to rise, the promise of upgrading to prime stayed intact. But when home prices peaked out in 2006 and began to fall the path out of subprime (and high mortgage rates) was blocked. This meant that subprime defaults were bound to soar. Combining this with early payment defaults by speculators, the value of mortgage backed securities declined sharply and set in motion the financial crisis.