Subprime lending
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 persons.
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
subprime lenders have engaged 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.Proponents of subprime lending maintain that the practice extends
credit to people who would otherwise not have access to the credit market.
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.
Background 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.Statistically, approximately 25% of the population of
the United States falls into this category.
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
American Dialect Society voted subprime the Word of the year for 2007 on
January 04, 2008.
Definition
While there is no official credit profile that describes a subprime
borrower, most in the United States have a credit score below 723. Fannie
Mae has lending guidelines for what it considers to be "prime" borrowers on
conforming loans. Their standard provides a good comparison between those
who are "prime borrowers" and those who are "subprime borrowers." Prime
borrowers have a credit score above 620 (credit scores are between 350 and
850 with a median in the U.S. of 678 and a mean of 723), a debt-to-income
ratio (DTI) no greater than 75% (meaning that no more than 75% of net
income pays for housing and other debt), and a combined loan to value ratio
of 90%, meaning that the borrower is paying a 10% downpayment. Any borrower
seeking a loan with less than those criteria is a subprime borrower by
Fannie Mae standards.
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 30 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 less than 620 (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
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. 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.
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 unforeseen and causing major
financial setbacks. 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 conventional loan for a large
purchase, such as an automobile. To meet this demand, lenders have seen
that a tiered pricing arrangement, one which allows these individuals to
receive loans but pay a higher interest rate, may allow loans which
otherwise would not occur.
From a servicing standpoint, these loans have higher collection defaults
and are more likely to experience repossessions and charge offs. Lenders
use the higher interest rate to offset these anticipated higher costs.
Provided that a consumer enters 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.
Continuing the example of an auto loan, 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 $4,220. A 6-percentage-point increase
in the rate caused slightly more than an 75% increase in the payment.
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.
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.Black and other minorities
disproportionately fall into the category of "subprime borrowers" because
of lower credit scores, higher debt-to-income ratios, and higher combined
loan to value ratios. Because they are higher risk borrowers, they are more
likely to seek subprime mortgages with higher interest rates than their
white counterparts. Even when median income levels were comparable, home
buyers in minority neighborhoods were more likely to get a loan from a
subprime lender. Interest rates and the availability of credit are often
tied to credit scores, and the results of a 2004 Texas Department of
Insurance study found that of the 2 million Texans surveyed, "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."African-Americans are in the aggregate less likely to have a higher
than average credit score and so take on higher levels of debt with smaller
down-payments than whites and Asians of similar incomes.
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.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.
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. 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.
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.
Several industry experts have suggested that the crisis may soon worsen
.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".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.
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.
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.
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.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.
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.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 6, 2007, 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
