Summary of findings
This document examines the growth of mortgage lending in the United States, with a focus on explaining the plethora of opaque, exotic, and increasingly complicated mortgage instruments that appeared following the deregulation of American banking in the 1970s. The introduction of these mortgage types was one of several reasons that contributed to the housing bubble that triggered the 2008 financial crisis. The document traces the historical growth of American residential mortgages in general, and exotic Adjustable Rate Mortgages in particular, after describing the most prevalent elements of subprime mortgages.
Adjustable-Rate Mortgage (“ARM”) (Glossary of Terms): A mortgage with a variable interest rate on the outstanding balance over the loan’s term. ARMs are sometimes known as “variable rate mortgages” or “floating rate mortgages.” Traditional or subprime ARMs are available. ARMs, which have long been the most popular type of residential mortgage outside of the United States, provide the advantage of protecting mortgage lenders from interest rate risk. Those who have ARMs can reset the mortgage interest rate at preset intervals when interest rates rise, forcing lenders to pay more to attract capital. 
However, in the run-up to the 2008 financial crisis, many ARMs took on characteristics that increased borrowers’ risks. During those years, adjustable-rate mortgages accounted for around 80% of all subprime mortgages granted in the United States.  ARM terms can vary significantly amongst loans. 2/28 ARMs and 3/27 ARMs, for example, are 30-year mortgages with a “teaser” rate for the first two or three years, followed by a higher variable rate. Borrowers with the most predatory ARMs face extremely high fees, and the loan principle can actually increase over time, resulting in higher long-term payments. 
Balloon Payment Mortgages: A payment plan with tiny starting instalments that build up to a much greater “balloon” payment at the end of the loan. Before the 1930s, practically all American residential mortgage lending was balloon loans, also known as partially or non-amortizing loans.  Not all balloon payment mortgages are subprime mortgages, however many subprime loans had a balloon payment provision in the run-up to the 2008 financial crisis. Balloon mortgages come in a variety of forms, including fixed rate, adjustable rate, and interest-only. Before the real estate bubble burst in the mid-2000s, the latter form of subprime mortgages, which drastically cut monthly payments, increased in popularity.
A fixed rate loan has an interest rate that does not fluctuate with market conditions. Because lenders are not insured against a rise in the cost of loanable funds when they create a fixed rate loan, fixed rate loans have higher beginning interest rates than adjustable rate mortgages (ARMs). 
Hybrid ARMs (also known as “fixed-period ARMs”) are similar to normal ARMs in that they start with a set interest rate period and then adjust later. Fixed-rate and adjustable-rate mortgage features are combined in hybrid ARMs. The 5/1 Hybrid ARM, for example, offers a five-year fixed rate, after which the interest rate changes annually in line with current interest rates. The 5/6 Hybrid ARM, therefore, starts with a fixed rate for five years and then adjusts every six months.
Interest-Only Mortgages: A loan having an initial period (typically between 3 and 10 years) during which the borrower only pays interest and no part of the debt before the loan resets, necessitating both principal and interest payments for the balance of the loan. The majority of mortgages having this interest-only provision are also adjustable-rate mortgages (ARMs). 
Prepayment penalties are fees paid by some loan borrowers when they pay off a loan or mortgage ahead of schedule, according to the conditions of the original mortgage agreement. Prepayment penalties are illegal in many areas, and Fannie Mae and Freddie Mac refuse to buy loans with them.  Prepayment penalties (fines paid to the borrower for paying off the loan before the contractual period) are believed to be present in 80% of subprime loans, compared to 2% of normal loans. 
NINJA stands for “No Income, No Job, and No Assets,” and is a type of mortgage. Prior to the financial crisis, NINJA mortgages were often cited as a feature of subprime mortgage lending. Borrowers must meet a credit score level specified by the lending institution and provide no extra proof of income or assets to qualify for these loans. NINJA loans often have a “teaser” rate that adjusts to a higher variable rate based on the borrower’s underlying credit risk. Legislation such as the Consumer Protection Act and Dodd-Frank Wall Street Reform began to impose stronger criteria for gathering borrower information in the years following the financial crisis, thereby eradicating NINJA loans. 
A mortgage with no down payment is one that does not require borrowers to put money down (or requires an exceedingly small down payment). This was a common practise in subprime mortgage financing before the financial crisis. It’s a hazardous loan for both the borrower and the lender because if property values fall, a borrower could soon owe more on a home than it’s worth, while a lender could be stuck with a loan where the borrower has little or no equity. 
This sort of adjustable-rate mortgage, often known as “pick-a-pay” or “payment-option mortgages,” allows borrowers to choose from a variety of payment options each month. A payment that covers both interest and principle, a payment that just covers interest, or a minimum payment that does not cover the entire interest-only sum are all alternatives. 
Refinance: Getting a new loan to pay off an old one. The previous loan’s terms, such as the rate, payment schedule, and other stipulations, are substituted with the new loan’s terms. Borrowers frequently refinance as interest rates fall in order to benefit from lower rates. Refinancing is the process of reassessing a person’s credit and repayment status; it might involve low or no fees, or large fees and tight restrictions. When the value of a home rises, refinancing allows certain borrowers to extract equity from the lender in the form of a cash payout. Some mortgage brokers and lenders attempted to encourage borrowers to refinance even when it was not in their best financial interests in the run-up to the financial crisis.
A subprime loan (also known as a “High-Cost” loan) is a loan that is generally given to those with low income and/or bad credit who would otherwise have trouble qualifying for a mortgage. There were borrowers who acquired subprime loans with higher interest rates in the run-up to the Great Financial Crisis who may have qualified for a conventional loan but were unaware of it. To compensate lenders for the heightened risk, subprime loans often have higher fees and interest rates. 
Teaser Rate: In general, a teaser rate is a low, initial rate. Some lenders famously charged a low starting rate to lure customers to take out a loan in the years leading up to the financial crisis, before rates reverted to typical market levels within a few years to a year.
Timeline of Subprime Mortgage Products and Adjustable Rate Mortgages
Adjustable rate mortgages (“ARMs”) became more widespread in the 1980s, partly as a result of the high interest rate environment. Depository institutions had to pay out more in interest to depositors as interest rates rose, and as a result, the loans they issued had to adjust as well. Some lenders offered “teaser rate” features to minimise initial monthly payments. These ARMs distinguished from traditional fixed-rate mortgages and normal variable-rate mortgages in that they gave a short-term fixed rate for the first 2 to 5 years (often referred to as a “teaser”) before resetting to a higher variable rate.
Philip Lehman explains the genesis of ARMs during his service as an Assistant Attorney General for North Carolina in an oral history interview for the American Predatory Lending project. Beginning in the late 1980s, Lehman noted two main changes: (1) mortgage brokers began to play a larger role in the market; and (2) “plain vanilla loans” gave way to more sophisticated mortgage loans with adjustable rates. Exhibit A demonstrates how financial companies touted ARMs as a tool to help more consumers secure a mortgage loan in Barron’s National Business and Financial Weekly in 1981.
subprime financing 1 – Subprime Financing
Interest-only ARMs, option ARMs, hybrid ARMs, and other ARM forms proliferated during the 1990s and especially the 2000s, allowing households with higher credit risk to more easily access capital while simultaneously increasing risks to individual borrowers and the wider financial system. Assistant Attorney General for Ohio Jeffrey Loeser mentions the impact Pay-Option ARMs had in subprime defaults in his oral history interview for the American Predatory Lending project. Borrowers on these Pay-Option adjustable rate mortgages pay a low interest rate at first, which then resets. These were dangerous, according to Loeser, because “a lot of predatory lending door-to-door [selling] even to consumers [who didn’t comprehend] what they were doing.” Loeser discusses how these tactics became more popular over the 1990s and 2000s.
Subprime lending via exotic ARMs (ARMs with features like a low two-year teaser rate followed by a payment reset) grew dramatically in the early 2000s.
 From $65 billion in 1995 to $173 billion in 2001, subprime mortgage originations surged.
 Between 2001 and 2004, the rapid growth in subprime loan origination continued, accompanied by an increase in the use of exotic loans.  According to data from Inside Mortgage Finance, three types of exotic loans – interest-only, option-adjustable-rate-loans (“option ARMs”), and 40-year balloons – rose from 7% to 29% of the mortgage market between 2004 and 2006.  Low interest rates, a healthy economy, and predictions of rising property prices in the early 2000s made subprime mortgage loans more accessible to borrowers with poor credit.  Subprime loans were almost exclusively used by borrowers to refinance existing mortgages in the 1980s and 1990s, although the percentage of subprime mortgage originations taken out as new mortgages increased with time. Subprime refinance loans, for example, accounting for just over half of all subprime loans by 2006. 
At the height of the financial crisis, the APL Team discovered that conventional ARMs had twice the delinquency rate of conventional fixed rate mortgages. At the height of the crisis in North Carolina, one out of every three subprime borrowers with an ARM was delinquent. The combination of ARMs with subprime borrowers, and in some cases outright fraud, was the driving force behind the decrease in housing prices. Subprime fixed-rate mortgage delinquency rates substantially mirrored subprime adjustable-rate mortgage default rates, according to the data.
Markets: Prime vs. Subprime
The proportion of ARMs in the prime origination market deviated dramatically from the prevalence in the subprime market in the run-up to 2008. ARM mortgages represented for only 10 to 30 percent of the prime market from 2003 to 2005.  However, ARM loans gained a larger share of the subprime market, rising from 30% of subprime mortgages in 1999 – matching the later-observed peak percentage in the prime market – to almost 50% of the subprime market between 2003 and 2006. Borrowers were expected to refinance these mortgages at rate resets, which was doable up until about 2004 while property prices rose and interest rates stayed low. However, as property values fell and interest rates on these mortgages rose, borrowers were hit with a wave of payment “shocks,” as they were unable to make the new, higher payments and were unable to refinance. As seen in Exhibit B, this resulted in a large increase in delinquencies. 
subprime lending number two – Subprime Lending
“Advertisement 48 – no Title,” says Exhibit C. Changing Times (1986-1991), 03, 91, 1988.
“They didn’t understand how the documentation worked, they didn’t understand how the loans operated, and they were losing their homes because of it,” Al Ripley, a Director in the North Carolina Justice Center since 2003, says in an American Predatory Lending interview. As a result, we began to witness more and more instances of that.” Markets for secondary and tertiary mortgages also got marketing that minimised risks. Exhibit C is an early investor-targeted advertisement touting the presumed safety of participating in adjustable-rate mortgage funds.
subprime lending number three – Subprime Lending
Subprime products frequently fostered predatory lending that disproportionately impacted minority populations, in addition to predatory advertising. Minority home ownership rates did not quickly increase until the early 1990s. The 1968 Fair Housing Act (FHA) built on the Civil Rights Act of 1964 by making it illegal to refuse mortgage loans or other real estate transactions based on race or ethnicity.  Despite the fact that this was a significant first step toward broader home ownership by race and ethnicity, the disparity between income and home prices prevented millions of people from purchasing homes. Subprime mortgage products were created by lenders to make houses more affordable. To give the appearance of affordability, these loans often concealed exorbitant charges, fees, and penalties. Throughout the United States, minority families have been disproportionately affected by predatory lending practises and foreclosures. “[S]ubprime loans are three times more probable in low-income communities, five times more likely in African-American neighbourhoods, and two times more likely in high-income black neighbourhoods than in low-income white neighbourhoods,” according to one study on the subject.  Furthermore, some subprime lenders particularly targeted minority areas, encouraging homeowners to refinance into more expensive mortgage products in order to deplete the borrower’s equity and leave them in a worse financial situation.
Adjustable-rate mortgages have grown in popularity as a portion of the mortgage market since the 1980s. Teaser rates, balloon payments, and “pick-a-pay” options were among the more unusual characteristics of mortgage loans. These emerging exotic ARMs disproportionately disadvantaged minority families and people who were more inclined to agree to loans with weaker credit restrictions and lower down payments. Exotic ARMs have been far less common since the financial crisis. From highs of a majority of new mortgage originations in the mid-1990s, the ARM share of recent residential mortgage originations has dropped to less than 10%.