What is Subprime Lending?
To understand why subprime lending still matters, you first need to understand how subprime lending contributed to the financial crisis a decade ago. Lending companies and credit agencies rank their borrowers by creditworthiness. Borrowers who are better able to repay their loans will receive higher credit scores, and lenders will be more willing to approve loans of larger amounts at lower interest rates. Loans made to subprime borrowers carry more risk of default. Borrowers classed as subprime will fall into one or more of several categories. They might have a history of either failing to pay loans on time or at all, be on low incomes or income support, or have no verifiable credit history, perhaps because they are young and have not borrowed before, or maybe they have recently moved from another country. Credit histories are not carried across countries.
Your history in the UK is completely independent from your US history, for example. As well as subprime borrowers, there are also subprime lending organisations. The name subprime comes from the fact that those with excellent credit histories are categorised as being “prime”, so those who rank lower are considered subprime. Sometimes, borrowers might be categorised as subprime even though they have a healthy credit history, but this usually only happens if they do not provide proof of their income and assets when applying for credit. This also happens if borrowers have recently immigrated and have no credit history in their new country.
How the Crisis Started
There were warning signs of an impending crisis as early as 2003. Banks in the US were approving as many mortgages as they could to meet a high demand for mortgage-backed securities. The thinking was that subprime lending was okay because if the borrower couldn't repay, the loan amount could be recouped by selling the house. Real estate prices were only going up, so there might even be some profit in it. By mid-2004, a real estate bubble was forming, and Federal Reserve Chairman Alan Greenspan decided to raise interest rates in an attempt to cool the market and prevent a bubble from forming and bursting. The Federal Reserve raised the base rate six times before the end of the year, up to 2.25% by December.
By December 2005, the rate was 4.25%. In 2006, the interest base rate went up again and was 5.25% by June. This progressive and relatively swift rise jacked up mortgage repayments for mortgage holders and placed too much stress on subprime borrowers who were already on higher interest rates and not in a position to keep up with these rises. As house prices fell, mortgagors found they could not sell their houses for more than what they owed, particularly those who had taken interest-only deals. Homeowners could not keep up with payments and could not sell. The result was lenders facing a large number of defaulting borrowers returning properties that were not worth what was owed on them to the mortgagees.
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The Big Boys Start to Collapse
Once house prices were falling and subprime mortgagors were defaulting en masse, the knock-on effects began to be felt through the investment community as products that had been sold against the mortgages in question lost value, damaging pensions, mutual funds and corporations that were invested in these kinds of derivatives. This in turn led to the 2007 banking crisis and the 2008 financial crisis. By 2007, the US government knew it would have to intervene, and in April of that year, it started trying to work with lenders to find a solution to avoid foreclosure on their customers. Despite their efforts, the government intervention was too little, too late.
Most of those affected had already gone under. By the end of 2007, the Federal Reserve had reduced base rates back down to 4.25%, but this also came too late. Inter-bank lending had already stalled, and banks thought to be too big to fail were starting to crumble. By this time, the Federal Reserve was taking measures to prop up the banks, and as 2008 approached, a full-blown financial crisis was under way. Lowering interest rates was not improving the situation, and in 2008, the Federal Reserve was forced to intervene and bail out the banks. However, even with government assistance, some banks had been hit too hard by the crisis and several, such as Washington Mutual Bank and Lehman Brothers, collapsed.
Reality Sets in and Bailouts Begin
It is difficult to see why subprime lending still matters when the US economy really did come close to complete collapse over the subprime lending crisis. At the height of the crisis, businesses were struggling to find enough funds to cover their daily operations. If things had continued the way they were going, shops were at risk of running out of food because delivery operators would have been unable to pay their operating costs. To make things worse, bailout measures were being rejected in the US House of Representatives because they were seen as measures to bail out Wall Street, which many potential voters perceive as an evil empire of greed. The stock market subsequently collapsed, and by that time, the future of the global economy was under threat.
- Too many subprime mortgages were approved
- Interest rate rises caused the housing market to deflate too quickly
- Mortgages that were propping up the stock market went into default
Interest rates govern the housing market, and the housing market was being used to prop up the financial markets. Turmoil in the US housing market had knock-on effects that were felt around the globe, and all of these threats stemmed from too many subprime mortgages being approved at a time when the economy was least able to weather the storm.
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Examining the Causes
Once the bailout measures were in place, inter-bank lending rates were able to normalise, and the loan market began to recover. This averted a global depression that would have had severe consequences even today. Even so, the whole fiasco caused a great deal of public resentment over how private financial organisations can act in what appeared to be an irresponsible way and then be bailed out by the government.
The public saw bankers as crooks that had got away with fleecing the system. Since then, many measures have been put in place to prevent a similar scenario from developing. There is more regulation over the mortgage market in all the world's major economies. This regulation requires a higher standard of proof of a borrower's ability to pay, preventing funds from being lent to people who simply lie about their assets and income on their application form. In some cases, “ninja loans” were made to people with no income, job or assets. Causes can be boiled down to a combination of:
- A fall in the housing market
- Demand for mortgage-backed securities
- Over-selling of subprime mortgage products
Analysts have since come to a consensus that it wasn't just the practice of subprime lending that caused the financial crisis and that blame can be distributed across lending practices, US housing policies, financial regulatory agencies, credit checking agencies as well as the borrowers themselves.
Return to Subprime
If you are looking for a subprime guide that can explain why subprime lending still matters, you can be assured that this credit class is still alive and well, although in a modified, toned-down form. Gone are the days of ninja loans and banks peddling massive interest-only mortgages to people who can scarcely afford to cover their monthly rent. Subprime finance still exists, but large loans like mortgages are far less likely to be taken out by subprime borrowers. These days, subprime credit is more likely to take the form of payday loans or car finance deals.
Subprime finance is attractive to lending companies because of the high rate of interest that can be charged. Charities and welfare organisations also argue that subprime lending can assist struggling, low-income households. Keeping the credit process ticking over is important to maintain growth in economies, and subprime lending ironically contributed to the recovery from the crisis caused by this very same class of credit. But even now, it is casting a shadow over the finance industry, as in 2017, defaults on car loans hit a high point in the US, and there is the ever-present threat of another crisis. Provided interest rates remain low, the threat of another collapse will remain just a threat without becoming a reality, but the markets are fragile, and it’s always possible for a crisis to turn into a disaster in a few short months.
Subprime Lending Today
Today, mortgage-backed securities are in play, and the derivatives they support can be traded through online brokerages. These will usually take the form of stocks or exchange-traded funds (ETFs) that, when you do your broker comparison, will be found to be available to trade through most online trading platforms. ETFs in particular are often factored in by traders when creating trading strategies. Subprime mortgages, while all but stamped out after the financial crisis, are starting to reappear as nonprime mortgages. These products are nowhere near as easy to have approved as their older subprime cousins, yet they are still being used in the same way – being sold on the secondaries market to be repackaged as mortgage-backed securities. This is why subprime lending still matters. The derivatives market worldwide is huge – some estimates put it as large as $1.2 quadrillion.
- Derivatives market creates demand
- Mortgages are needed to feed demand
- To create more mortgages, subprime customers are taken on
While such an enormous market exists, the components that go into the mix are always going to be in demand, and that includes saleable mortgages, subprime or otherwise. One factor that is at play and complicating matters is the difficulty millennials are having gaining access to the property ladder. In many cases, a nonprime mortgage is their only way to become homeowners, and without such products, they would be frozen out of the market completely.
Subprime is still important
Subprime lending still matters for a variety of reasons, including the fact that mortgages can still be resold and repackaged as mortgage-backed securities, which in turn can be taken to the open market and used as tradable financial instruments through online brokerages. This is a healthy aspect of the stock market and is not likely to go away any time soon. It is when the mortgages turn toxic and mass defaults start happening that the trouble starts. Provided lenders play by the rules and don't lend to subprime customers who are certain to default, the system can continue without coming to grief.
The other reason that subprime lending needs to continue is so that those who have a legitimate reason for not having a good credit score are able to access credit and with good management, will be able to build a higher credit score, eventually earning prime borrower status. Used wisely, all types of credit, even subprime, can greatly improve the economy for everyone involved.