What Is Subprime Lending?

From wikipedia:

In general, subprime lending (also known as B-paper, near-prime, or second chance lending) is lending at a higher rate than the prime rate. However, in US mortgage lending specifically, the term "subprime" simply refers to loans that do not meet Fannie Mae or Freddie Mac guidelines. While often defined or defended as lending to borrowers with compromised cr histories, the Wall Street Journal reported in 2006, 61% of all borrowers receiving subprime loans had cr scores high enough to qualify for prime conventional loans.1Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, allegedly poor cr histories (which can be extraordinarily inaccurate) and potentially adverse financial situations that are sometimes associated with subprime applicants. A subprime loan is offered at a rate higher than A-paper loans due to the perceived increased risk. Subprime lending encompasses a variety of cr instruments, including subprime mortgages, subprime car loans, and subprime cr cards. The most abusive subprime lending practices are, arguably, short-term "payday" loans.

Subprime lending is highly controversial. 2 Proponents of subprime lending maintain that the practice extends cr to people who would otherwise not have access to the cr market.3

As the result of an ongoing lending and cr crisis in the subprime industry, and in the greater financial markets which began in the United States, the controversy surrounding subprime lending has expanded. Subprime fixed mortgages represented 6.3% of outstanding loans and 12.0% of the foreclosures started in the same period.4

Fannie Mae has lending guidelines for what it considers to be "prime" borrowers on conforming mortgage loans – those loans they will buy or securitize into the cr market.

 Subprime lenders

To access this increasing market, lenders often take on risks associated with lending to people with allegedly poor cr ratings. Subprime loans are considered to carry a far greater risk for the lender due to the aforementioned cr risk characteristics of the typical subprime borrower. In the case of many subprime loans, this risk is offset with a higher interest rate or various cr enhancements such as Private Mortgage Insurance (PMI). In the case of subprime cr cards, a subprime customer may be charged higher late fees, higher over limit fees, yearly fees, or up front fees for the card.

 Borrower profiles

Subprime can offer an opportunity for borrowers with an allegedly less than ideal cr record to gain access to cr. Borrowers may use this cr 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 cr card. However, due to the risk profile of the subprime borrower, this access to cr comes at the price of higher interest rates, increased fees and other increased costs.

Judgment, foreclosure, repossession, or non-payment of a loan in the past;

 Private Label Cr

A combination of aggressive deferred interest programming and predatory interest rate and penalty fee policies result in high default rates that must be offset by those aggressive lending practices.

 Types

 Subprime Origination, Securitization and Servicing

Some subprime originators (mortgage companies or brokers) sell high-risk residential or commercial loans with a variety of gimmicks that can trap low income borrowers into loans with increasing yield terms that eventually exceed borrower’s capability to make the payments. Commercial mortgages carry the “Depositor” warranty by a Mortgage Loan Purchase Agreement (MLPA) registered with the SEC as part of securitization registration.

This shortfall continues to accumulate interest at default rates which form additional “Servicing Income.” The shortfall of loan repayment is usually repaid as a result of ”Repurchase Demand” by Special Servicer on GSE or loan seller to REMIC Trust also called “Loan Depositor.”

 Subprime mortgages

Like other subprime loans, subprime mortgages are defined by the financial and cr profile of the consumers to which they are marketed. 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 cr history. Subprime borrowers are generally defined as individuals with limited income or having FICO cr 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. Subprime mortgages totaled $600 billion in 2006, accounting for about one-fifth of the U.S. home loan market2.

As with other types of mortgage, various special loan features are available with subprime mortgages, including:

interest-only payments, which allow borrowers to pay only interest for a period of time (typically 5–10 years);

"pay option" loans, usually with adjustable rates, 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 so-called "hybrid" mortgages with initial fixed rates that sooner or later convert to adjustable rates.

This last class of mortgages has grown particularly popular among subprime lenders since the 1990s. Common subprime hybrids 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.

 Subprime cr cards

Cr card companies in the United States began offering subprime cr cards to borrowers with low cr scores and a history of defaults or bankruptcy in the 1990s when usury laws were relaxed. These cards usually begin with low cr limits and usually carry extremely high fees and interest rates as high as 30% or more.6In 2007, many new subprime cr cards began to sprout forth in the market. In a very limited number of situations, subprime cr cards may help a consumer improve poor cr scores. 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 and higher fees, may allow loans which otherwise would not occur.

From a servicing standpoint, these loans have a statistically higher rate of default and are more likely to experience repossessions and charge offs. Lenders use the higher interest rate and fees to offset these anticipated higher costs.

The same goes for loans. Allegedly less crworthy 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. Most subprime ARM loans are tied to LIBOR (London Interbank Offered Rate – a rate trading system originating in Britain). ARM interest rates usually adjust once a year or per quarter, and the rate is based a calculation specified in the loan documents. Though some subprime borrowers may be able to repair their cr rating over time, some default again and may even turn to bankruptcy.

 Mortgage discrimination

Main article: Mortgage discrimination

Some subprime lending practices have raised concerns about mortgage discrimination on the basis of race.2Because they are higher risk borrowers, they are more likely to seek subprime mortgages with higher interest rates than their white counterparts.8

 U.S. subprime mortgage crisis

A steep rise in the rate of subprime mortgage defaults and 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.10With market paranoia setting in, banks reined in their lending to each other and to business, leading to rising interest rates and difficulty in maintaining cr lines. 13 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. 17 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 cr than subprime borrowers at not quite prime rates.18

3. Pass funding to support mortgage counseling. In late March of 2008, Friedman Billings Ramsey 5 reported the default rate on securitized subprime loans hit 25.2% in December of 2007. Alt-A loan defaults also increased to 8.65%. (The default rate includes loans 90 days or more past due, in foreclosure, and real estate owned.)

 

  1. ^ Rick Brooks & Ruth Simon, Subprime Debacle Traps Even Very Credit-Worthy: As Housing Boomed,Industry Pushed Loans To a Broader Market, Wall Street Journal, Dec. 3, 2007, at A1
  2. ^ a b c Study Finds Disparities in Mortgages by Race The New York Times By MANNY FERNANDEZ Published: October 15, 2007
  3. ^ Goolsbee, Austan. "‘Irresponsible’ Mortgages Have Opened Doors to Many of the Excluded", Economic Scene, The New York Times, 200703-29. Retrieved on 200708-12. "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.”" 
  4. ^ http://www.mbaa.org/NewsandMedia/PressCenter/58758.htm
  5. ^ American Dialect Society
  6. ^ "Need a Loan? No Problem."
  7. ^ CardTrak.com – Most Trusted Source of Credit Cards Since 1986
  8. ^ NAACP Fights Loan Discrimination
  9. ^ Weston, Liz Pulliam, "Is your insurer discriminating against you?", MSN Money, <http://articles.moneycentral.msn.com/Insurance/KnowYourRights/IsYourInsurerDiscriminatingAgainstYou.aspx> 
  10. ^ Morgenson, Gretchen. "Crisis Looms in Market for Mortgages". The New York Times, March 11, 2007. Retrieved April 19, 2007.
  11. ^ http://biz.yahoo.com/ap/070312/mortgage_meltdown_q_a.html?.v=1
  12. ^ The Mortgage Lender Implode-O-Meter – tracking the housing finance breakdown, related to Alt-A and subprime mortgages, lending fraud, predatory lending, housing bubble, mortgage banking, foreclosures, debt, consolidation, lawyers, class-action lawsuits
  13. ^ Opening Statement of Chairman Chris Dodd – Hearing on Mortgage Market Turmoil: Causes and Consequences. United States Senate (200703-22). “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.”
  14. ^ Christie, Les. "Subprime blame game", CNNMoney.com, CNN. Retrieved on 200708-12. "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." 
  15. ^ Morgenson, Gretchen. "FAIR GAME; Home Loans: A Nightmare Grows Darker". The New York Times, April 8, 2007. Retrieved on March 23, 2008.
  16. ^ "Has the Housing Crisis Finally Arrived?" The Trumpet.com, March 29, 2007. Retrieved on April 19, 2007.
  17. ^ Subprime lenders deny responsibility – Mar. 22, 2007
  18. ^ Fleckenstein, Bill. "Next: The real estate market freeze". MSN.com, March 12, 2007. Retrieved on April 19, 2007.
  19. ^ Strasburg, Jenny. "Subprime Defaults to Soar, Hurt Lenders, Funds Say". Bloomberg.com, March 15, 2007. Retrieved on April 19, 2007.
  20. ^ Associated Press. "Will subprime mess ripple through economy". MSN.com, March 13, 2007. Retrieved on April 19, 2007.
  21. ^ Durrant, Brian. Will the US subprime crisis cause a UK property meltdown?MoneyWeek, April 13, 2007
  22. ^ Zibel, Alan and Dan Caterinicchia (200704-11). "U.S. Housing Aid needed, Schumer says". Retrieved on 200704-19.
  23. ^ TOBY ANDERSON, AP Business Writer (200708-15). "European markets slide; Asia closes down". Retrieved on 200708-15.
  24. ^ Fact Sheet: Helping American Families Keep Their Homes

About Luke Ford

Raised a Seventh-Day Adventist at Avondale College in Australia, Luke Ford moved to California in 1977. He graduated from Placer High School in 1984, reported the news at KAHI/KHYL radio for three years, attended Sierra College and UCLA, was largely bedridden by Chronic Fatigue Syndrome for six years, and converted to Judaism in 1993. From 1997-2007, Luke made his living from blogging. Living by Beverly Hills (Alexander90210.com), he now teaches the Alexander Technique (moving the way the body likes to move). Lessons cost $100 each and last about 45 minutes. In 2011, Luke completed a three-year teaching course at the Alexander Training Institute of Los Angeles. His personal Alexander Technique website is Alexander90210.com. Luke is the author of five books, including: » The Producers: Profiles in Frustration » Yesterday’s News Tomorrow: Inside American Jewish Journalism
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