In
finance, subprime lending (also referred to as near-prime, subpar, non-prime, and second-chance lending) is the provision of
loan
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that ...
s to people in the United States who may have difficulty maintaining the repayment schedule.
Historically, subprime borrowers were defined as having
FICO scores below 600, although this threshold has varied over time.
These loans are characterized by higher interest rates, poor quality collateral, and less favorable terms in order to compensate for higher credit risk. Many subprime loans were packaged into
mortgage-backed securities
A mortgage-backed security (MBS) is a type of asset-backed security (an 'instrument') which is secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals (a government agency or investment ba ...
(MBS) and ultimately
defaulted, contributing to the
financial crisis of 2007–2008
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fi ...
.
[Lemke, Lins and Picard, ''Mortgage-Backed Securities'', Chapter 3 (Thomson West, 2013 ed.).]
Defining subprime risk
The term ''subprime'' refers to the credit quality of particular borrowers, who have weakened credit histories and a greater risk of loan default than prime borrowers.
As people become economically active, records are created relating to their borrowing, earning, and lending histories. This is called a
credit rating
A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting.
...
; although covered by
privacy laws, the information is readily available to people with a need to know (in some countries, loan applications specifically allow the lender to access such records).
Subprime borrowers have credit ratings that might include:
* limited or no debt experience;
* limited or no possession of property
asset
In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can ...
s that could be used as
security" \n\n\nsecurity.txt is a proposed standard for websites' security information that is meant to allow security researchers to easily report security vulnerabilities. The standard prescribes a text file called \"security.txt\" in the well known locat ...
(for the lender to sell in case of default);
* excessive debt
* the known income of the individual or family is unlikely to be enough to pay living expenses, plus interest and repayment;
* a history of late or sometimes missed payments;
* failures to pay debts completely (default debt);
* legal judgments such as "orders to pay" or
bankruptcy (sometimes known in Britain as
County Court judgment
Description
In England and Wales, County Court judgments (CCJs) are legal decisions handed down by the County Court. Judgments for monetary sums are entered on the statutory Register of Judgments, Orders and Fines, which is checked by credit ref ...
s or CCJs).
Lenders' standards for determining risk categories may also consider the size of the proposed loan, and also take into account the way the loan and the repayment plan is structured, if it is a conventional
repayment loan, a
mortgage loan
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any ...
, an
endowment mortgage An endowment mortgage is a mortgage loan arranged on an interest-only basis where the capital is intended to be repaid by one or more (usually Low-Cost) endowment policies. The phrase "endowment mortgage" is used mainly in the United Kingdom by le ...
, an
interest-only loan An interest-only loan is a loan in which the borrower pays only the interest for some or all of the term, with the principal balance unchanged during the interest-only period. At the end of the interest-only term the borrower must renegotiate anothe ...
, a
standard repayment loan, an
amortized loan, a
credit card
A credit card is a payment card issued to users (cardholders) to enable the cardholder to pay a merchant for goods and services based on the cardholder's accrued debt (i.e., promise to the card issuer to pay them for the amounts plus the o ...
limit or some other arrangement. The originator is also taken into consideration. Because of this, it was possible for a loan to a borrower with "prime" characteristics (e.g. high
credit score, low debt) to be classified as subprime.
Proponents of subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market. Professor
Harvey S. Rosen
Harvey Sheldon Rosen (born 29 March 1949) is an American Economist and Academic. Prior to his retirement and subsequent appointment as Emeritus Professor in 2019, Rosen was the John L. Weinberg Professor of Economics and Business Policy at Prin ...
of
Princeton University
Princeton University is a private research university in Princeton, New Jersey. Founded in 1746 in Elizabeth as the College of New Jersey, Princeton is the fourth-oldest institution of higher education in the United States and one of the ...
explained, "The main thing that innovations in the mortgage market have done over the past 30 years is to let in the excluded: the young, the discriminated against, the people without a lot of money in the bank to use for a down payment."
Student loans
In the
United States
The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country primarily located in North America. It consists of 50 states, a federal district, five major unincorporated territori ...
the amount of student loan debt surpassed credit card debt, hitting the $1 trillion mark in 2012.
However, that $1 trillion rapidly grew by 50% to $1.5 trillion as of 2018. In other countries such loans are
underwritten
Underwriting (UW) services are provided by some large financial institutions, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liabili ...
by governments or sponsors. Many student loans are structured in special ways because of the difficulty of predicting students' future earnings. These structures may be in the form of
soft loan
A soft loan is a loan with a below-market rate of interest. This is also known as ''soft financing''. Sometimes soft loans provide other concessions to borrowers, such as long repayment periods or interest holidays. Soft loans are usually provid ...
s,
income-sensitive repayment There are a number of loan repayment options available to U.S. federal student loan borrowers, including some that are based on the borrower’s income. Income-sensitive repayment lets Federal Family Education Loan Program (FFELP) borrowers decide ...
loans,
income-contingent repayment
Income-contingent repayment is an arrangement for the repayment of a loan where the regular (e.g. monthly) amount to be paid by the borrower depends on his or her income. This type of repayment arrangement is mostly used for student loans, where th ...
loans and so on. Because student loans provide repayment records for credit rating, and may also indicate their earning potential,
student loan default can cause serious problems later in life as an individual wishes to make a substantial purchase on credit such as
purchasing a vehicle or buying a house, since defaulters are likely to be classified as subprime, which means the loan may be refused or more difficult to arrange and certainly more expensive than for someone with a perfect repayment record.
United States
Although there is no single, standard definition, in the
United States
The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country primarily located in North America. It consists of 50 states, a federal district, five major unincorporated territori ...
subprime loans are usually classified as those where the borrower has a
FICO score
A credit score is a number that provides a comparative estimate of an individual's creditworthiness based on an analysis of their credit report. It is an inexpensive and main alternative to other forms of consumer loan underwriting.
Lenders, s ...
below 600. The term was popularized by the media during the
subprime mortgage crisis or "credit crunch" of 2007. Those loans which do not meet
Fannie Mae
The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, is a United States government-sponsored enterprise (GSE) and, since 1968, a publicly traded company. Founded in 1938 during the Great Depression as part of the N ...
or
Freddie Mac
The Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, is a publicly traded, government-sponsored enterprise (GSE), headquartered in Tysons Corner, Virginia.[underwriting
Underwriting (UW) services are provided by some large financial institutions, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liabili ...]
guidelines for prime mortgages are called "non-conforming" loans. As such, they cannot be packaged into Fannie Mae or Freddie Mac MBS and have less secondary market liquidity.
A borrower with a history of always making repayments on time and in full will get what is called an A grade paper loan. Borrowers with less-than-perfect credit scores might be rated as meriting an A-minus, B-paper, C-paper or D-paper loan, with interest payments progressively increased for less reliable payers to allow the company to share the risk of default equitably among all its borrowers. Between A-paper and subprime in risk is a grade called
Alt-A An Alt-A mortgage, short for Alternative A-paper, is a type of U.S. mortgage that, for various reasons, is considered riskier than A-paper, or "prime", and less risky than " subprime," the riskiest category. For these reasons, as well as in some c ...
. A-minus is related to Alt-A, with some lenders categorizing them the same, but A-minus is traditionally defined as mortgage borrowers with a
FICO score
A credit score is a number that provides a comparative estimate of an individual's creditworthiness based on an analysis of their credit report. It is an inexpensive and main alternative to other forms of consumer loan underwriting.
Lenders, s ...
of below 660 while Alt-A is traditionally defined as loans lacking full documentation or with alternative documentation of ability to repay . The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-
lien
A lien ( or ) is a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation. The owner of the property, who grants the lien, is referred to as the ''lienee'' and the per ...
subprime mortgages outstanding.
Canada
The sub-prime market did not take hold in Canada to the extent that it did in the U.S., where the vast majority of mortgages were originated by third parties and then packaged and sold to investors who often did not understand the associated risk.
Subprime crisis
The
subprime mortgage crisis arose from "bundling" American subprime and American regular mortgages into
mortgage-backed securities
A mortgage-backed security (MBS) is a type of asset-backed security (an 'instrument') which is secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals (a government agency or investment ba ...
(MBSs) that were traditionally isolated from, and sold in a separate market from,
prime loans.
These "bundles" of mixed (prime and subprime) mortgages were based on
asset-backed securities so the probable rate of return looked very good (since subprime lenders pay higher premiums on loans secured against saleable real-estate, which was commonly assumed "could not fail"). Many subprime mortgages had a low initial interest rate for the first two or three years and those who defaulted were
'swapped' regularly at first, but finally, a bigger share of borrowers began to default in staggering numbers. The inflated
house-price bubble burst, property valuations plummeted and the real rate of return on investment could not be estimated, and so confidence in these instruments collapsed, and all less than prime mortgages were considered to be almost worthless
toxic asset A toxic asset is a financial asset that has fallen in value significantly and for which there is no longer a functioning market. Such assets cannot be sold at a price satisfactory to the holder. Because assets are offset against liabilities and freq ...
s, regardless of their actual composition or performance. Because of the "originate-to-distribute" model followed by many subprime mortgage originators, there was little monitoring of credit quality and little effort at remediation when these mortgages became troubled.
Subprime loans as aggressive lending tools. Markets with a high concentration of aggressive lending facilities are at risk of a sharper fall in real estate prices after a negative shock to demand.
To avoid high initial mortgage payments, many subprime borrowers took out
adjustable-rate mortgage
A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets.Wie ...
s (or ARMs) that give them a lower initial interest rate. But with potential annual adjustments of 2% or more per year, these loans can end up costing much more. So a $500,000 loan at a 4% interest rate for 30 years equates to a payment of about $2,400 a month. But the same loan at 10% for 27 years (after the adjustable period ends) equates to a payment of $4,220. A 6-percentage-point increase (from 4% to 10%) in the rate caused slightly more than a 75% increase in the payment.
This is even more apparent when the lifetime cost of the loan is considered (though most people will want to refinance their loans periodically). The total cost of the above loan at 4% is $864,000, while the higher rate of 10% would incur a lifetime cost of $1,367,280.
See also
*
Amortization (business)
In accounting, amortization refers to expensing the acquisition cost minus the residual value of intangible assets in a systematic manner over their estimated "useful economic lives" so as to reflect their consumption, expiry, and obsolescence, o ...
*
Collateral (finance)
*
Endowment mortgage An endowment mortgage is a mortgage loan arranged on an interest-only basis where the capital is intended to be repaid by one or more (usually Low-Cost) endowment policies. The phrase "endowment mortgage" is used mainly in the United Kingdom by le ...
*
Graduated payments
*
Microcredit
*
Mortgage loan
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any ...
*
Soft loan
A soft loan is a loan with a below-market rate of interest. This is also known as ''soft financing''. Sometimes soft loans provide other concessions to borrowers, such as long repayment periods or interest holidays. Soft loans are usually provid ...
*
Student loan default
References
External links
J F Bellod, "La Crisis Imposible"Wolves Feeding On BailoutNPR.com
''Businessweek''.
Workers Say Lender Ran 'Boiler Rooms'Michael Hudson and E. Scott Reckard, Los Angeles Times, February 4, 2005.
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The Cleveland Plain-Dealer investigation into the complicity of lenders in the Cleveland foreclosure mess. May 2008
*
"From Sub-Prime to Prime-Time - A Debate on the Current Financial Crisis"A panel of economists at Columbia University, School of International and Public Affairs, Feb 28, 2008.
“What you ought to know about missold mortgages”Are mis-sold mortgages a problem for Banks and Brokers? June 8, 2018
{{DEFAULTSORT:Subprime Lending
Subprime mortgage crisis
Financial economics
Interest rates
Personal finance