Subprime lending
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Subprime lending (also known as B-paper, near-prime, or second chance lending) is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. The phrase also refers to banknotes taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and certain types of self-employed individuals.
Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, poor credit history, and adverse financial situations usually associated with subprime applicants. A subprime loan is offered at a rate higher than A-paper loans due to the increased risk. Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others. The term "subprime" refers to the credit status of the borrower (being less than ideal), not the interest rate on the loan itself.
Subprime lending is highly controversial. Opponents have alleged that the subprime lending companies engage in predatory lending practices such as deliberately lending to borrowers who could never meet the terms of their loans, thus leading to default, seizure of collateral, and foreclosure. There have also been charges of mortgage discrimination on the basis of race.<ref name="nytimes">Study Finds Disparities in Mortgages by Race The New York Times By MANNY FERNANDEZ Published: October 15, 2007</ref> Proponents of the subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market.<ref name="a"> Goolsbee , Austan
. " 'Irresponsible' Mortgages Have Opened Doors to Many of the Excluded " , Economic Scene , The New York Times , 2007-03-29 . Retrieved on 2007-08-12 . "Professor Rosen explains, “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.”" </ref>
The controversy surrounding subprime lending has expanded as the result of an ongoing lending and credit crisis both in the subprime industry, and in the greater financial markets which began in the United States. This phenomenon has been described as a financial contagion which has led to a restriction on the availability of credit in world financial markets. Hundreds of thousands of borrowers have been forced to default and several major American subprime lenders have filed for bankruptcy.
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History
Subprime lending evolved with the realization of a demand in the marketplace and businesses providing a supply to meet it. With bankruptcies and consumer proposals being widely accessible, a constantly fluctuating economic environment, and consumer debt loan on the rise, traditional lenders are more cautious and have been turning away a record number of potential customers.[citation needed] Statistically, approximately 25% of the population of the United States falls into this category.[citation needed]
In the third quarter of 2007, Subprime ARMs only represent 6.8% of the mortgages outstanding in the US, yet they represent 43.0% of the foreclosures started. Subprime fixed mortgages represent 6.3% of outstanding loans and 12.0% of the foreclosures started in the same period. <ref> http://www.mbaa.org/NewsandMedia/PressCenter/58758.htm</ref>
Definition
While there is no official credit profile that describes a subprime borrower, most in the United States have a credit score below 620. <ref>Subprime mortgages </ref>
Subprime lenders
To access this increasing market, lenders often take on risks associated with lending to people with poor credit ratings. Subprime loans are considered to carry a far greater risk for the lender due to the aforementioned credit risk characteristics of the typical subprime borrower. Lenders use a variety of methods to offset these risks. In the case of many subprime loans, this risk is offset with a higher interest rate. In the case of subprime credit cards, a subprime customer may be charged higher late fees, higher over limit fees, yearly fees, or up front fees for the card. Subprime credit card customers, unlike prime credit card customers, are generally not given a "grace period" to pay late. These late fees are then charged to the account, which may drive the customer over their credit limit, resulting in over limit fees. Thus the fees compound, resulting in higher returns for the lenders. These increased fees compound the difficulty of the mortgage for the subprime borrower, who is defined as such by their unsuitability for credit.
Subprime borrowers
Subprime offers an opportunity for borrowers with a less than ideal credit record to gain access to credit. Borrowers may use this credit to purchase homes, or in the case of a cash out refinance, finance other forms of spending such as purchasing a car, paying for living expenses, remodeling a home, or even paying down on a high interest credit card. However, due to the risk profile of the subprime borrower, this access to credit comes at the price of higher interest rates. On a more positive note, subprime lending (and mortgages in particular), provide a method of "credit repair"; if borrowers maintain a good payment record, they should be able to refinance back onto mainstream rates after a period of time. Credit repair usually takes twelve months to achieve; however, in the UK, most subprime mortgages have a two or three-year tie-in, and borrowers may face additional charges for replacing their mortgages before the tie-in has expired.
Generally, subprime borrowers will display a range of credit risk characteristics that may include one or more of the following:
- Two or more loan payments paid past 60 days due in the last 12 months, or one or more loan payments paid past 90 days due the last 36 months;
- Judgment, foreclosure, repossession, or non-payment of a loan in the prior 48 months;
- Bankruptcy in the last 7 years;
- Relatively high default probability as evidenced by, for example, a credit bureau risk score (FICO) of 620 or below (depending on the product/collateral), or other bureau or proprietary scores with an equivalent default probability likelihood.
Types
Subprime mortgages
As with subprime lending in general, subprime mortgages are usually defined by the type of consumer to which they are made available. According to the U.S. Department of Treasury guidelines issued in 2001, "Subprime borrowers typically have weakened credit histories that include payment deliquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories."
In addition, many subprime mortgages have been made to borrowers who lack legal immigration status in the United States [1]
Subprime mortgage loans are riskier loans in that they are made to borrowers unable to qualify under traditional, more stringent criteria due to a limited or blemished credit history. Subprime borrowers are generally defined as individuals with limited income or having FICO credit scores below 620 on a scale that ranges from 300 to 850. Subprime mortgage loans have a much higher rate of default than prime mortgage loans and are priced based on the risk assumed by the lender.
Although most home loans do not fall into this category, subprime mortgages proliferated in the early part of the 21st Century. About 21 percent of all mortgage originations from 2004 through 2006 were subprime, up from 9 percent from 1996 through 2004, says John Lonski, chief economist for Moody's Investors Service. Subprime mortgages totaled $600 billion in 2006, accounting for about one-fifth of the U.S. home loan market.
There are many different kinds of subprime mortgages, including:
- interest-only mortgages, which allow borrowers to pay only interest for a period of time (typically 5-10 years);
- "pick a payment" loans, for which borrowers choose their monthly payment (full payment, interest only, or a minimum payment which may be lower than the payment required to reduce the balance of the loan);
- and initial fixed rate mortgages that quickly convert to variable rates.
This last class of mortgages has grown particularly popular among subprime lenders since the 1990s. Common lending vehicles within this group include the "2-28 loan", which offers a low initial interest rate that stays fixed for two years after which the loan resets to a higher adjustable rate for the remaining life of the loan, in this case 28 years. The new interest rate is typically set at some margin over an index, for example, 5% over a 12-month LIBOR. Variations on the "2-28" include the "3-27" and the "5-25".
Subprime credit cards
Credit card companies in the United States began offering subprime credit cards to borrowers with low credit scores and a history of defaults or bankruptcy in the 1990s. These cards usually begin with low credit limits and usually carry extremely high fees and interest rates as high as 30% or more.<ref>"Need a Loan? No Problem."</ref> In 2002, as economic growth in the United States slowed, the default rates for subprime credit card holders increased dramatically, and many subprime credit card issuers were forced to scale back or cease operations.<ref>http://www.cardweb.com/cardtrak/pastissues/aug02.html</ref>
In 2007, many new subprime credit cards began to sprout forth in the market. As more vendors emerged, the market became more competitive, forcing issuers to make the cards more attractive to consumers. Interest rates on subprime cards now start at 9.9% but in some cases still range up to 24% APR.
Subprime credit cards however can help a consumer improve poor credit scores. Most subprime cards report to major credit reporting agencies such as TransUnion and Equifax. Consumers that pay their bills on time should see positive reporting to these agencies within 90 days.
Proponents
Individuals who have experienced severe financial problems are usually labelled as higher risk and therefore have greater difficulty obtaining credit, especially for large purchases such as automobiles or real estate. These individuals may have had job loss, previous debt or marital problems, or unexpected medical issues, usually these events were unforeseen and cause a major setback in finances. As a result, late payments, charge-offs, repossessions and even foreclosures may result.
Due to these previous credit problems, these individuals may also be precluded from obtaining any type of loan for an automobile. To meet this demand, lenders have seen that a tiered pricing arrangement, one which allows these individuals to pay a higher interest rate, may allow loans which otherwise may not occur.
From a servicing standpoint, these loans have higher collection defaults and experience higher repossessions and charge offs. Lenders use the higher interest rate to offset these anticipated higher costs.
Provided a consumer will enter into this arrangement with the understanding that they are higher risk, and must make diligent efforts to pay, these loans do indeed serve those who would otherwise be underserved. The consumer must purchase an automobile which is well within their means, and carries a payment well within their budget.
Criticism
Capital markets operate on the basic premise of risk versus reward. Investors taking a risk on stocks expect a higher rate of return than do investors in risk-free Treasury bills, which are backed by the full faith and credit of the United States. The same goes for loans. Less creditworthy subprime borrowers represent a riskier investment, so lenders will charge them a higher interest rate than they would charge a prime borrower for the same loan.
To avoid the initial hit of higher mortgage payments, most subprime borrowers take 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 charging 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 $4,470. A 6-percentage-point increase in the rate caused slightly more than an 85% increase in the payment.[2]
On the other hand, interest rates on ARMs can also go down - in the US, the interest rate is tied to federal government-controlled interest rates, so when the Fed cuts rates, ARM rates go down, too. ARM interest rates usually adjust once a year, and the rate is based on an average of the federal rates over the last 12 months. Also, most ARMs limit the amount of change in a rate.[3]
The cycle of increased fees due to default-prone borrowers defaulting is a vicious cycle. Though some subprime borrowers may be able to repair their credit rating, many default and enter the vicious cycle. While this enhances the profits of the subprime lender, it also leads to further vicious cycling as the subprime lenders are unable to recover what has been lent to subprime borrowers. Hence the current subprime mortgage crisis.
Mortgage discrimination
Some subprime lending practices have raised concerns about mortgage discrimination on the basis of race.<ref name="nytimes">Study Finds Disparities in Mortgages by Race The New York Times By MANNY FERNANDEZ Published: October 15, 2007</ref> African Americans and other minorities are being disproportionately led to sub-prime mortgages with higher interest rates than their white counterparts.<ref>NAACP Fights Loan Discrimination</ref> Even when median income levels were comparable, home buyers in minority neighborhoods were more likely to get a loan from a subprime lender.<ref name="nytimes"/> Because interest rates and the availability of credit are often tied to credit scores, this may be due to a finding that "black policyholders had average credit scores that were 10% to 35% worse than those of white policyholders. Hispanics' average scores were 5% to 25% worse, while Asians' scores were roughly the same as whites."<ref>[articles.moneycentral.msn.com/Insurance/KnowYourRights/IsYourInsurerDiscriminatingAgainstYou.aspx]</ref>
U.S. subprime mortgage crisis
Beginning in late 2006, the U.S. subprime mortgage industry entered what many observers have begun to refer to as a meltdown. A steep rise in the rate of subprime mortgage foreclosures has caused more than 100 subprime mortgage lenders to fail or file for bankruptcy, most prominently New Century Financial Corporation, previously the nation's second biggest subprime lender.<ref>Morgenson, Gretchen. http://select.nytimes.com/search/restricted/article?res=F00914FE3B550C728DDDAA0894DF404482 News Analysis: Crisis Looms in Mortgages". The New York Times, March 11, 2007. Retrieved April 19, 2007.</ref> The failure of these companies has caused prices in the $6.5 trillion mortgage backed securities market to collapse, threatening broader impacts on the U.S. housing market and economy as a whole. The crisis is ongoing and has received considerable attention from the U.S. media and from lawmakers during the first half of 2007.<ref>http://biz.yahoo.com/ap/070312/mortgage_meltdown_q_a.html?.v=1</ref><ref>http://www.ml-implode.com/</ref>
However, the crisis has had far-reaching consequences across the world. Sub-prime debts were repackaged by banks and trading houses into attractive-looking investment vehicles and securities that were snapped up by banks, traders and hedge funds on the US, European and Asian markets. Thus when the crisis hit the subprime mortgage industry, those who bought into the market suddenly found their investments near-valueless. With market paranoia setting in, banks reined in their lending to each other and to business, leading to rising interest rates and difficulty in maintaining credit lines. As a result, ordinary, run-of-the-mill and healthy businesses across the world with no direct connection whatsoever to US sub-prime suddenly started facing difficulties or even folding due to the banks' unwillingness to budge on credit lines.
Observers of the meltdown have cast blame widely. Some have highlighted the predatory practices of subprime lenders and the lack of effective government oversight.<ref name="s200703">
However, the crisis has had far-reaching consequences across the world. Sub-prime debts were repackaged by banks and trading houses into attractive-looking investment vehicles and securities that were snapped up by banks, traders and hedge funds on the US, European and Asian markets. Thus when the crisis hit the subprime mortgage industry, those who bought into the market suddenly found their investments near-valueless. With market paranoia setting in, banks reined in their lending to each other and to business, leading to rising interest rates and difficulty in maintaining credit lines. As a result, ordinary, run-of-the-mill and healthy businesses across the world with no direct connection whatsoever to US sub-prime suddenly started facing difficulties or even folding due to the banks' unwillingness to budge on credit lines.
Observers of the meltdown have cast blame widely. Some have highlighted the predatory practices of subprime lenders and the lack of effective government oversight.<ref name="s200703"> Opening Statement of Chairman Chris Dodd - Hearing on Mortgage Market Turmoil: Causes and Consequences
. United States Senate (2007-03-22)
. “people paying the price for the regulators’ inaction are homeowners across America struggling ... Homeownership is supposed to be a ticket to the middle class. Predatory lending reverses the trip.” </ref> Others have charged mortgage brokers with steering borrowers to unaffordable loans, appraisers with inflating housing values, and Wall Street investors with backing subprime mortgage securities without verifying the strength of the underlying loans. Borrowers have also been criticized for entering into loan agreements they could not meet.<ref name="c2007"> Christie , Les
. " Subprime blame game " , CNNMoney.com , CNN . Retrieved on 2007-08-12 . "In the end, they are responsible for deciding that they could afford the mortgage and signing the papers. No one forced them to take on a loan the couldn't afford." </ref>
Many accounts of the crisis also highlight the role of falling home prices since 2005. As housing prices rose from 2000 to 2005, borrowers having difficulty meeting their payments were still building equity, thus making it easier for them to refinance or sell their homes. But as home prices have weakened in many parts of the country, these strategies have become less available to subprime borrowers.<ref>Morgenson, Gretchen. "FAIR GAME; Home Loans: A Nightmare Grows Darker". The New York Times, April 8, 2007. Retrieved on April 19, 2007.</ref>
Several industry experts have suggested that the crisis may soon worsen. Lewis "Lewie" Ranieri, formerly of Salomon Brothers, considered the inventor of the mortgage-backed securities market in the 1970s, warned of the future impact of mortgage defaults: "This is the leading edge of the storm. … If you think this is bad, imagine what it's going to be like in the middle of the crisis." <ref>"Has the Housing Crisis Finally Arrived?" The Trumpet.com, March 29, 2007. Retrieved on April 19, 2007.</ref> Echoing these concerns, consumer rights attorney Irv Ackelsberg predicted in testimony to the U.S. Senate Banking Committee that five million foreclosures may occur over the next several years as interest rates on subprime mortgages issued in 2004 and 2005 reset from the initial, lower, fixed rate to the higher, floating adjustable rate or "adjustable rate mortgage".<ref>http://money.cnn.com/2007/03/22/real_estate/subprime_lenders_deny_responsibility/index.htm?postversion=2007032218</ref> Other experts have raised concerns that the crisis may spread to the so-called Alternative-A (Alt-A) mortgage sector, which makes loans to borrowers with better credit than subprime borrowers at not quite prime rates.<ref>Fleckenstein, Bill. "Next: The real estate market freeze". MSN.com, March 12, 2007. Retrieved on April 19, 2007.</ref>
Some economists, including former Federal Reserve Board chairman Alan Greenspan, have expressed concerns that the subprime mortgage crisis will affect the housing industry and even the entire U.S. economy. In such a scenario, anticipated defaults on subprime mortgages and tighter lending standards could combine to drive down home values, making homeowners feel less wealthy and thus contributing to a gradual decline in spending that weakens the economy.<ref>Strasburg, Jenny. "Subprime Defaults to Soar, Hurt Lenders, Funds Say". Bloomberg.com, March 15, 2007. Retrieved on April 19, 2007.</ref>
Other economists, such as Edward Leamer, an economist with the UCLA Anderson Forecast, doubts home prices will fall dramatically because most owners won't have to sell, but still predicts home values will remain flat or slightly depressed for the next three or four years.<ref>Associated Press. "Will subprime mess ripple through economy". MSN.com, March 13, 2007. Retrieved on April 19, 2007.</ref>
In the UK, some commentators have predicted that the UK housing market will in fact be largely unaffected by the US subprime crisis, and have classed it as a localised phenomenon.<ref>Durrant, Brian. Will the US subprime crisis cause a UK property meltdown?MoneyWeek, April 13, 2007</ref> However, in September 2007 Northern Rock, the UK's fifth largest mortgage provider, had to seek emergency funding from the Bank of England, the UK's central bank as a result of problems in international credit markets attributed to the sub-prime lending crisis.
As the crisis has unfolded and predictions about it strengthening have increased, some Democratic lawmakers, such as Senators Charles Schumer, Robert Menendez, and Sherrod Brown have suggested that the U.S. government should offer funding to help troubled borrowers avoid losing their homes.<ref> Zibel, Alan and Dan Caterinicchia
(2007-04-11) . "U.S. Housing Aid needed, Schumer says"
. Retrieved on 2007-04-19. </ref> Some economists criticize the proposed bailout, saying it could have the effect of causing more defaults or encouraging riskier lending.
On August 15, 2007, concerns about the subprime mortgage lending industry caused a sharp drop in stocks across the Nasdaq and Dow Jones, which affected almost all the stock markets worldwide. Record lows were observed in stock market prices across the Asian and European continents.<ref> TOBY ANDERSON, AP Business Writer
(2007-08-15) . "European markets slide; Asia closes down"
. Retrieved on 2007-08-15. </ref> The U.S. market had recovered all those losses within 2 days.
Concern in late 2007 increased as the August market recovery was lost, in spite of the Fed cutting interest rates by half a point (0.5%) on September 18 and by a quarter point (0.25%) on October 31. Stocks are testing their lows of August now.
On December 62007, President Bush announced a plan to voluntarily and temporarily freeze the mortgages of a limited number of mortgage debtors holding ARMs by the Hope Now Alliance. He also asked members Of Congress to: 1. Pass legislation to modernize the FHA. 2. Temporarily reform the tax code to help homeowners refinance during this time of housing market stress. 3. Pass funding to support mortgage counseling. 4. Pass legislation to reform Government Sponsored Enterprises (GSEs) like Freddie Mac and Fannie Mae. <ref> http://www.whitehouse.gov/news/releases/2007/12/20071206-7.html </ref>.
See also
- 2007 Subprime mortgage financial crisis
- Adverse credit history
- Hope Now Alliance
- Negative amortization
References
External links
(2007-03-20) . Blacks and Hispanics to Suffer Most from Subprime Crisis . The Daily Reckoning
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- Peter Coy
(2007-03-02) . Why Subprime Lenders Are In Trouble . Business Week
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. United States Department of Housing and Urban Development (2006-03-24)
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(2004-05-21) . Subprime Mortgage Lending: Benefits, Costs, and Challenges . Board of Governors of the Federal Reserve System
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. BBC (2007-03-14)
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. NERA Economic Consulting
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