Subprime lending

Not such a lucrative market

As financial institutions announce varying degrees of difficulties and losses caused by toxic assets and bad debts on their balance sheets, and as the US housing market is further subjected to even more repossessions, the word ‘subprime’ has become synonymous with these events.

Subprime is the practise whereby a lender gives a loan to a borrower who does not qualify for a good interest rate because of a poor credit history. In effect, ‘subprime mortgages’ refers to lending mortgages to people with bad credit.

The beginning of the subprime mortgage crisis started back in 2001, when the US economy was first hit by the dotcom bubble crash, which was then followed by the events that took place on September 11th. In the wake of this the US Federal Reserve dropped interest rates to 1 per cent, making borrowing cheap as the US housing market began to boom. Many mortgage lenders thought they saw a particularly lucrative market by lending to adverse credit subprime borrowers, because they would be able to charge higher interest rates for the riskier customers.

As house prices continued to increase until 2006, refinancing these mortgages through homeowner loans or remortgaging was relatively easy. However, house prices had risen sharply along with interest rates, and by the end of 2006 house prices began to deflate. Soon the US housing bubble popped and house prices slumped, leaving many people in a position where they found it difficult to refinance due to negative equity in their property. People began to default on their mortgages, which simply meant that they couldn’t pay. This became even more apparent during 2007 and 2008 with many more properties being repossessed as a consequence.
A considerable number of mortgage lenders who leant to subprime borrowers repackaged their debt as mortgage backed securities (MBS). The cash flow of these is backed by the principal and monthly interest payments of mortgages. Because of the boom in the US housing markets, many banks and hedge funds saw MBSs as good investment opportunities. However, when the cash flow on them stopped due to borrowers defaulting, the securities lost their value, resulting in huge losses for those that had invested in them. As a result these events have had a knock on effect on credit markets and the wider world economy.