Subprime lending

In finance, subprime lending (also referred to as near-prime, subpar, non-prime, and second-chance lending) is the provision of loans to people who may have difficulty maintaining the repayment schedule.[1] Historically, subprime borrowers were defined as having FICO scores below 600, although this threshold has varied over time.[2]

"Subprime" redirects here. For the 2007 house mortgage crisis, see Subprime mortgage crisis.

These loans are characterized by higher interest rates, poor quality collateral, and less favorable terms in order to compensate for higher credit risk.[3] Many subprime loans were packaged into mortgage-backed securities (MBS) and ultimately defaulted, contributing to the financial crisis of 2007–2008.[4]

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.[5] As people become economically active, records are created relating to their borrowing, earning and lending history. This is called a credit rating; 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 debt experience (so the lender's assessor simply does not know, and assumes the worst), or
  • no possession of property assets that could be used as security (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 + interest + repayment),
  • a history of late or sometimes missed payments so that the loan period had to be extended,
  • failures to pay debts completely (default debt), and
  • any legal judgments such as "orders to pay" or bankruptcy (sometimes known in Britain as county court judgments 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, an endowment mortgage, an interest-only loan, a standard repayment loan, an amortized loan, a credit card 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.[6]

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 of Princeton University 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."[7]

Student loans

In the United States the amount of student loan debt recently surpassed credit card debt, hitting the $1 trillion mark in 2012.[8][9] However, that $1 trillion rapidly grew by 50% [10] to $1.5 trillion as of 2018.[11] In other countries such loans are underwritten 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 loans, income-sensitive repayment loans, income-contingent repayment 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.[9]

United States

Although there is no single, standard definition, in the United States subprime loans are usually classified as those where the borrower has a FICO score below 640. 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 or Freddie Mac underwriting guidelines for prime mortgages are called "non-conforming" loans. As such, they cannot be packaged into Fannie Mae or Freddie Mac MBS.[12]

A borrower with a history of always making repayments on time and in full will get what is called an A-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 Alt-A. 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 of below 680 while Alt-A is traditionally defined as loans lacking full documentation.[13] The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007,[14] with over 7.5 million first-lien subprime mortgages outstanding.[15]

Canada

The sub-prime market did not take hold in Canada to the extent that it did in the U.S.,[16][17] 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
Main article: Subprime mortgage crisis

The subprime mortgage crisis arose from "bundling" American subprime and American regular mortgages into mortgage-backed securities (MBSs) that were traditionally isolated from, and sold in a separate market from, prime loans.[4] 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 assets, 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.[4]

To avoid high initial mortgage payments, many subprime borrowers took out adjustable-rate mortgages (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.[18] 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.

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See also

References
  1. The Financial Crisis Inquiry Report (PDF). National Commission on the Causes of the Financial and Economic Crisis in the United States. 2011. p. 67.
  2. Lo, Andrew W. "Reading About the Financial Crisis: A 21-Book Review" (PDF). Draft: January 9, 2012. Journal of Economic Literature. Archived from the original (PDF) on 13 January 2013. Retrieved 17 November 2013. The term “subprime” refers to the credit quality of the mortgage borrower as determined by various consumer credit-rating bureaus such as FICO, Equifax, and Experian. The highest-quality borrowers are referred to as “prime”, hence the term “prime rate” refers to the interest rate charged on loans to such low-default-risk individuals. Accordingly, “subprime” borrowers have lower credit scores and are more likely to default than prime borrowers. Historically, this group was defined as borrowers with FICO scores below 600, although this has varied over time and circumstances, making it harder to determine what “subprime” really means.
  3. "Subprime Lending". U.S. Department of Housing and Urban Development. Archived from the original on 2016-07-02. Retrieved 2018-09-21.
  4. Lemke, Lins and Picard, Mortgage-Backed Securities, Chapter 3 (Thomson West, 2013 ed.).
  5. "FDIC-Guidance for Subprime Lending". Fdic.gov. Retrieved May 1, 2010.
  6. Demanyank Y. (2009). Ten Myths about Subprime Mortgages Archived 2013-06-05 at the Wayback Machine. Federal Reserve Bank of Cleveland.
  7. Goolsbee, Austan (2007-03-29). "Irresponsible Mortgages Have Opened Doors to Many of the Excluded". Economic Scene. The New York Times. Retrieved 2010-12-03.
  8. "Student Loan Debt Exceeds One Trillion Dollars". www.NPR.org. NPR. Retrieved 19 January 2015.
  9. Martin, Andrew (8 September 2012). "Debt Collectors Cashing In on Student Loans". New York Times. Retrieved 17 May 2017. ..many borrowers are struggling to pay off their student loans, and the debt collection industry is cashing in.
  10. Lobosco, Katie. "Student loan debt just hit $1.5 trillion. Women hold most of it". cnn.com.
  11. Friedman, Zack. "Student Loan Debt Statistics In 2018: A $1.5 Trillion Crisis". forbes.com.
  12. Lemke, Lins and Picard, Mortgage-Backed Securities, Chapter 2 (Thomson West, 2013 ed.).
  13. Alt-A Mortgages.
  14. "How severe is subprime mess?". NBC News. Associated Press. March 13, 2007. Retrieved July 13, 2008.
  15. Ben S. Bernanke (May 17, 2007). The Subprime Mortgage Market (Speech). Chicago, Illinois. Retrieved July 13, 2008.
  16. "What subprime crisis?". National Post. 2007-09-08. Archived from the original on 2016-01-30. Retrieved 2015-12-28.
  17. Greg McArthur; Jacquie McNish (2009-03-14). "Canada's dirty subprime secret". Retrieved 2015-12-28.
  18. Gad, Sham (2007-07-10). "The Skinny on Subprime". Fool.com. Retrieved 2010-05-01.
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