Subprime Lending

Subprime lending is a term for when a loan is provided to candidates whose credit worthiness is deemed as a risk. When an individual needs money they obtain it from a bank as a loan. Banks provide loans to individuals based on their credit worthiness, a standard deduced from a myriad of parameters. Examples of these include whether they have returned any loan in the past, whether they paid in full, if payments were made on time or if they defaulted on any of the payments. Credit card use can also used to estimate risk. The bank will examine if a potential loan recipient is in good standing with the credit card company, whether they have made payments on time and are not termed as regular defaulters or a high risk individuals. Subprime lending provides loans to people even if they do not have credentials that prove that they would be able to repay the loan. It is a high risk, high return system. Subprime lenders look for a high return on the risk they are taking by providing loans to high credit risk individuals.

Subprime lending provides credit to people to whom traditional credit markets would refuse loan to. Professor Harvey S. Rosen of Princeton University explains that mortgage markets have innovated products for people who otherwise would not have even enough money for their first down payment to live as equals without discrimination.

To define subprime risk we need to understand how credit histories are created. As people move through life they become more active in their spending patterns, creating a bread crumb trail behind them which is read by the credit rating agencies. This study of the crumb trail is also called credit rating. This is treated as a confidential file for use only to banks who would need this information to provide loan to a candidate. This trail might include all or some of the examples below. This list is not exhaustive and is only indicative:

• Limited debt experience, or the individual asking for a loan doesn’t have a crumb trail behind him – This could happen due to a multitude of causes, most prominent being that the individual is young and does not have a history of activity in the financial market. They may be a student or a first time entrepreneur. In such a case the individual automatically becomes high risk credit rating individual as the banks assume the worst.
• If the individual doesn’t possess any property that could be used as a security or a pawn in the event that the individual defaults.
• If the individual already has a high debt load and their expenses are more than their earnings.
• If the individual has a credit history marked with default payments or late payments. Also if the individual has been penalized with extended payment in the past.
• Past inability to pay debts.

Credit risk may also depend on factors such as the type of loan that an individual is opting for, whether a mortgage loan or a dull repayment loan or a credit card limit or some other arrangement with the provider of loan.

Education Loans

In some other countries student loans are treated as subprime lending since the guarantee that a student would return their loan after completing study is considered a risky bet. Additionally, students are generally young and have limited credit histories, inherently increasing their credit riskiness.  The interest on the loan would also depend on the type of study the student is seeking to get admission to – whether graduation or post-graduation, or whether from an Ivy League or from some other institution. Many students may have difficulties paying off the loan immediately following graduation, eventually causing them to default and subsequently tainting their credit history. If they later want to go for a loan for a car or a house this may cause serious problems. They may then be classified as subprime, signifying that loaning to them would be a risky affair and forcing them to opt for a high interest rate loan rather than someone with a perfect payment record.

United States of America

There is no standard definition for subprime loans in the United States of America. Generally what the lenders consider is called as the FICO scores or the Fair Isaac Corporation score. Those who have their Fair Isaac Corporation score below 640 are considered as subprime loans. This term was widely talked about when the subprime crises hit the world in 2007.

Individuals with an outstanding repayment record and on time payment would be classified as a good borrower and may be classified as a A-paper loan, and those with less than perfect history would be given A minus, B or C or even D paper loans. Each of these would in turn have higher interest payment respectively. The highest interest rate would be for those who have high chances of defaulting.

What is Subprime crisis

The subprime crisis began when financial institutions started bundling the prime and the subprime loans together. This bundling was viewed by investors as foolproof. The prime loan was supposed to ensure that the return would be assured, while the subprime loans ensured high interest rates while the entire package was backed by the security of the asset itself. If the loan defaulted, the real estate would become the property of the lender and hence in no way it could be considered as a not safe bet.

The tipping point into dangerous territory occurred when the bubble in the real-estate prices (in part initiated by the easy access of subprime loans) began to burst. The asset-backed loans started to default when the period of adjustable rate mortgage ended and the interest rates rose. Loans began defaulting. In turn, defaulting loans in the subprime category were so high that real estate prices began to collapse, meaning that banks could not sell the property (real estate) to recover their loans since the value of the real estate had fallen below the estimate made when the loan was issued. So a house worth 500,000 dollars at the time when the loan was provided may be worth 40,000 dollars less than when the bubble burst happen. The provider of the loan was caught between a defaulting borrower and devalued real estate which may not even be sale-able as there were no takers for it. This led to a domino effect in which not only the banks were caught, but nearly everyone who was connected to any financial instrument that dealt with subprime lending.