Despite the troubles, subprime mortgages and mortgage refinances will likely make a comeback in a more conservatively managed and administered form.

Subprimes were once the darlings of Wall Street, just like junk bonds in the tumultuous 1980s, before those high-risk instruments sank the global stock markets. With subprime loans, Wall Street bet that bad mortgages could be bundled with good ones, and then sold to investors with diluted risk. Unfortunately, that conjecture failed miserably. Any apple farmer will tell you that putting a rotten fruit into a bushel basket of perfectly good ones will yield devastating results. When the subprimes where strategically added into the mix, they weighed down better-performing loans. This rather reckless practice essentially put good money against bad.

Today, the results are still being tallied on the downside, as lenders, homeowners, investors, and corporate executives suffer the ongoing ramifications. Subprimes have taken down the earnings of hedge funds, banks, and other financial giants in a crisis that some believe is only the tip of the iceberg in this mortgage meltdown.

Subprime mortgages will rise again

Subprime mortgages may have caused an industry collapse, but they are still valuable tools for the mortgage industry and their customers. Many experts predict that it will rise again, albeit in an altered form. Most people will likely follow the "once burned, twice shy" maxim, but lenders and legislators will probably figure out how to control risk while continuing to offer some version of these types of loans.

Many industry watchers expect Congress to allow the Federal Housing Administration to increase its lending scope in the subprime arena. In addition, reforms being discussed now to regulate the subprime industry will eventually be agreed upon, made into law, and stringently enforced.

Changes in the subprime sector

One change that most experts predict will be stronger consumer protection. That's because subprimes need to be offered to people with bad credit, without preying upon them. Other potential changes include:

  • No prepayment penalties for subprime loans.
  • No charging of unfair rates, or putting unqualified consumers-or those who could qualify for prime loans- into more expensive subprime products.
  • More consumer education and transparency, so that when someone takes out a mortgage or does a mortgage refinance, he clearly understands the terms of the loan.
  • Less leveraging of assets that serve as loan collateral.

A basic tenet of the U.S. housing philosophy is to increase home ownership so that more and more people can realize their share of the American Dream. Subprime lending-which essentially means the practice of lending money to people with poor credit-plays a critical role in fulfilling those goals. That's why government and industry don't want to see subprimes disappear. Expect them to rise again, someday.

Those new subprimes, which will look much different from their ugly predecessors, are a necessary component of America's lending industry. Without them, many homebuyers will be prevented from taking out mortgages, and homeowners will be limited in their mortgage refinance options.

Published on February 13, 2014