The collateralized debt obligations (“CDOs”) and other subprime securities sold to investors in 2006 and 2007 were virtually guaranteed to pose big problems for investors. The harsh reality is that most of these securities were nothing more than bets by Wall Street that home prices would continue to rise at unrealistic rates in the future. Moreover, even if housing prices rose at their historic norms, the painful truth is that these securities were still likely to fail.
While investors continue to lose millions of dollars as the collapse of the subprime housing market continues to have ripple effects throughout the U.S. economy, many cannot help but question how we ever got into this morass. Indeed, hardly a day goes by without a news report suggesting that credit problems are worsening or that a major economic slowdown, if not recession, looms on the horizon. Surprisingly, the answer may be much simpler than some experts have led us to believe.
The sad fact is that many subprime mortgages issued in 2006 and 2007 — estimated to total $362 billion — were in default even before interest rates on these loans reset to new higher rates in 2008. While interest rate adjustments will certainly contribute to the record number of residential mortgage defaults and foreclosures that housing industry analysts predict will occur in future years, they are not the primary cause of the turmoil in the subprime market. The problem is not that when the loan resets, the higher loan payments will be beyond the homeowner’s means. The problem is that the borrower could never afford the home in the first place regardless of the low initial “teaser” interest rate.