In the Rose Garden last Friday, the President proposed policy changes to address problems in the subprime mortgage market. Here are his remarks and a fact sheet. I’m going to do this in three parts: (1) give a few definitions for those who are new to the housing finance world; (2) define the problem; and (3) explain the President’s new proposals.

Let’s begin with a few definitions:

1. A subprime mortgage is one in which there is more risk to the lender than from a prime borrower. A subprime mortgage may be to a borrower with poor credit, or for a loan with little or no down payment, no mortgage insurance, or little or no documentation of income. Note that subprime does not necessarily mean low income. Subprime mortgages are just as high a percentage of big loans (jumbos, in which the loan amount is >$417K) as of smaller loans.
2. An ARM is an adjustable rate mortgage. This is in contrast to a fixed rate mortgage. In an ARM, the interest rate changes over time.
3. A 2/28 mortgage is a specific type of subprime ARM. Typically, you pay a low fixed teaser interest rate for two years (and often no principal). In month 25, your interest rate resets to a (much) higher rate. Your monthly mortgage payments jump, in some cases quite dramatically. And your interest rate continues to reset every six months after the first reset. A 2/28 mortgage (or its cousin, a 3/27) is one in which the interest rate starts low, then jumps after two years. In most cases, you put little or no money down, and you’re hoping that the value of the home will appreciate significantly during those first two years. If it does, you can probably refinance with an affordable fixed rate, since you now have equity in the home. But if the house does not appreciate in value (or if it depreciates), you’re stuck with much higher monthly payments. Problem: In some cases, people bought such a mortgage where they realistically would never be able to afford the higher monthly payments after the reset. In some markets housing prices have declined over the past two years. These people are having trouble making their higher (post-teaser) monthly mortgage payments. So, for instance, imagine a $200,000 30-year subprime ARM, which has a 7% teaser rate […]