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Booyah Breakdown: Subprime Time

Here's a look at what the subprime market is and why it's causing so much trouble lately.

Neither a borrower nor a lender be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry.

-- Lord Polonius, in Shakespeare's



Homeownership is close to 70% these days. You can thank historically low interest rates and the president's push to have every American own a home. But that ownership translates into more than $9 trillion in outstanding mortgage debt these days.

Of that amount, about 20% is in subprime loans. And unless you've been under a rock, you've heard about the looming explosion of the subprime market.

Cramer has been talking about it daily. And while he's pretty bearish on the whole mortgage sector, he's "cautious" about the subprime arena. "I am worried. But I am not scared and I am not panicking," he said in a

recent column.

So what exactly is this explosive subprime industry that can single-handedly pull the economy into the toilet? The Booyah Breakdown is going to try to dissect that dilemma today. We'll analyze the different players and try to understand the potential fallout.

The Borrowers

"Subprime is a mortgage-industry term referring to folks with less than stellar credit," explains Keith Gumbinger, vice president of HSH Associates of Pompton Plains, N.J., which tracks a variety of loan products.

A credit score of 700 or higher is considered very good. That means you pay your bills on time and don't have any bankruptcies under your belt. But if you have missed payments, filed for bankruptcy or have delinquencies in your past, your credit score will most likely fall to anywhere from 500 to 600.

At that point, you're considered a subprime borrower, meaning your credit is less than prime. No surprise, many low-income folks fall into this category.

But what if the guy with bad credit, a.k.a. the subprime guy, still wants to buy a home? He won't qualify for a regular -- or prime -- 30-year mortgage. The interest rate for that is hovering around a very nice 6.14% these days, the lowest level since mid-December.

The subprime borrower has no choice but to seek a more expensive loan that will allow for his not-so-clean past.

That means he needs a subprime loan. The typical subprime loan is called the 2/28 adjustable-rate mortgage (ARM). That means that for the first two years, the interest rate will be fixed. Because the borrower is a risk, the interest rate will be very high -- anywhere from 9% to 12%. After the two fixed years, the interest rate will adjust, usually annually, on the basis of an index plus some extra percentage points, for the remaining 28 years of the loan.

The typical 2/28 loan adjusts around LIBOR (London interbank offered rate) plus 6%. LIBOR is around 5.25% these days. Add 6% to that, and you're looking at a rate of 11.25% if those two fixed years expired and the loan started to adjust today.

Let's say our subprime guy wants to buy a house. He sits down with a subprime lender, and they go over his financial position. Everyone agrees that he can afford the monthly mortgage payment -- even with the high fixed interest rate.

Our subprime guy is then (presumably) told that as long as he makes 24 consecutive mortgage payments at that fixed rate, his credit score will improve. Then at the end of the fixed-two-year term, he will be able to refinance into a better, lower-rate loan.

Seems simple enough, right? Just pay your monthly mortgage bill, and we'll assume you're on your way to the American dream.

But we all watched the

Odd Couple

, so we know what happens when you assume. (More on that later.)

The Lenders

A subprime lender is an institution that lends money to borrowers who don't qualify for mainstream -- or prime -- loans. The industry has been around for years but was little noticed outside of daytime TV commercials. Think of the old-school subprime houses, like Champion Mortgage ("When your bank says no, Champion says Yes!") and Phil Rizzuto's commercials for the Money Store.

These days, companies such as New Century,

Fremont General





are the ones we've been hearing about.

But big bigger mortgage houses, such as




Washington Mutual

(WM) - Get Free Report





Wells Fargo

(WFC) - Get Free Report

, have subprime divisions as well. (Check out Cramer's

dirty dozen list of subprime shorts.)

Lenders charge subprime borrowers much higher rates and fees to make up for the greater risk involved with offering subprime loans, notes Mark Grinis, a partner in Ernst & Young's Real Estate, hospitality and construction group. Subprime lending costs are higher because more applications are rejected and marketing costs are higher.

And it should come as no surprise that a higher percentage of subprime loans go into default than their prime loan brethren.

But these lenders are fully aware of the risks associated with granting subprime loans. In the past, it was assumed that about 9% to 10% of subprime borrowers would default on their loans, says Gumbinger. So the banks would reserve for those losses.

These days, however, about 13%, or 2.2 million people, in the subprime sector are in some form of delinquency. That means banks are now under-reserved.

Herein lies the problem.

The Fallout

So back to our

Odd Couple

episode where Felix Unger tells us that when we "assume," we make an "ass" out of "u" and "me."

We "assumed" our borrower would make his 24 consecutive mortgage payments. But he didn't, and two years later, his credit score is still in the toilet. Now he can't refinance out of his 2/28 loan and is looking at defaulting.

In this case, the lender has two options. He can either work with the delinquent borrower and create better payment terms, or he can foreclose on the guy's house. But banks are not in the business of owning homes. That's just an added expense and headache.

Here's where the trouble starts. If the banks do foreclose, they'll quickly want to dump those properties back into the market, because they don't want to hold them. That increases the inventory of homes available for sale, and that, in turn, depresses the selling price of all the homes in the area. Add that to an already ailing housing market, and we've got problems.

"The most significant impact will be caused by the disruption from foreclosures," says Grinis. "As many as one out of every 10 home sales in certain neighborhoods will be sold by a court proceeding or sheriff sale," he says.

Granted, some areas will get hit worse then others. States such as Louisiana and Mississippi have a high number of subprime borrowers, and -- no surprise -- their default rates are rocketing. Whereas more stable areas, such as Connecticut and New Hampshire, will not feel as much subprime pain.

So could this turn catastrophic? Probably not. Interest rates still remain favorable, the economy is still pretty solid, and job growth is still good. But are we near end of subprime issues? No way.

The peripheral affects are hard to estimate, says Grinis. We're starting to see some spread into the prime mortgage market as companies such as



H&R Block

(HRB) - Get Free Report



(GM) - Get Free Report

recently reported that the subprime sectors of their businesses hurt their overall earnings numbers.

And if housing prices continue to fall, thanks to all these defaults, that means less equity in people's pockets, and you know what happens from there.

Thankfully, lenders are have raised their standards (which they should have never lowered) on subprime borrowers. But unfortunately, that's too little, too late.

While we're far from done with the subprime pain, it will be a few months before we really get a feel for what the damage will be. Cramer argues that if

Federal Reserve

Chairman Ben Bernanke lowers rates, that could help dull the pain. But then there's that pesky risk of inflation to worry about.

So for now, all we can do is wait -- and continue to make our monthly mortgage payments so we don't add to this mess.

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;

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