Subprime lending refers to the tradition of making loans to borrowers with particular credit features. For instance, FICO counts lower than 620, which disqualify the borrowers from credit at the rate equivalent to that of prime credit, and this is the origin of the expression subprime. It is also known as nonprime, second chance spending as well as near prime. The borrowers are people with difficulty in maintaining a repayment schedule. It encompasses different kinds of credits such as credit cards, mortgages as well as auto loans. Subprime borrowers are considered more risky than prime borrowers, because they have poor credit histories. For this reason, they are charged a premium to compensate for the risk. The interest rate is high for mortgages as well as other fixed-term loans. On the other hand, late fees are implied for credit cards. Individuals who may otherwise be denied do not receive the credit despite the associated high costs. Therefore, near prime lending is a stepping-stone to credit repair through preserving a good payment record on the loans. Borrowers are at liberty to ascertain that they are worthy the credit and ultimately paying back their credit at lesser or primer rates (Rogers, Powell, & Grant-Thomas, 2008).
Subprime lending became famous in the mid-1990s in the United States. At the time, the outstanding debt increased in 2003 to $332 from the 1993 figure, which was $33 billion. The estimated figure in subprime mortgages was outstanding as in December 2007 it was $1.3 trillion (Berry, 2007). In 2006, 20% of the mortgages were considered near prime, which is a rate not thought about in the past 10 years. The notable increase can be related to industry enthusiasm. In this, banks as well as other lenders found they could make heinous profits from trading the securities to investors, origination fees, and from bundling mortgages into securities. The banks together with the lenders believed they could manage the nonprime loans’ risks. This belief was fad by persistently rising home prices as well as the recognized stability of the securities backed by mortgages. According to Peterson (2007), the 2006 steady decrease in the prices of homes led to the likelihood of real houses although the logic of the belief may have sustained for a short time. Many borrowers realized that the money they owed on their mortgage as home value declined exceeding their home worth. The borrowers started to avoid repayment of their loans thereby driving down the home prices further, which wrecked the value of securities backed by mortgage. This downward cycle caused a meltdown on the mortgage industry.
Nonprime lending has extensive implications on many firms with direct effects on financial institutions, home-building concerns, and on lenders. The value of property in the United States’ housing market has crashed down whereas the industry is overflowing with houses, but with no purchasers. The situation has affected the entire economy as lenders are investing in stable assets such as treasury securities or hoarding cash instead of lending money for consumer spending as well as business growth. This has caused a general credit crisis in 2007. The commercial real estate market has also been affected by the subprime crisis although not similarly to the effect on residential industry because assets used for commercial reasons have preserved their prolonged value (Peterson, 2007).
Brief History of Subprime Lending
Nonprime mortgage market loans money to individuals who cannot afford credit or standards necessary for ordinary mortgages. These have passed the threat to investors all over the globe who are enthusiastic to purchase securities backed by mortgages thereby carrying more yields than those issued by safer investments like the United States Treasury bonds. Subprime mortgages are inherently risky because the borrowers are people with credit problems or are low-income earners and chances are that they will not pay back the debts. Banks as well as other lenders impose more money on the interest charged on subprime mortgages to counteract the additional risk. These increased rates have been 2% more than the prime rates for the past 10 years thereby making subprime lending potentially rewarding. The subprime industry took off in the middle of 1990s although it always had existed (Rogers, Powell, & Grant-Thomas, 2008). Previously, lenders deemed the risk too huge to issue a considerable amount of debt. However, this opinion changed because of numerous factors thereby motivating banks to create subprime mortgages in larger numbers. Below is a graph showing how mortgages have increased over time.
Graph 1 (Stanford, n.d)
Factors that Motivated Subprime Lending
Appreciation of Home Prices
From the mid-1990s up-to-date, appreciation of home prices has appeared to be an unstoppable trend.
Many lenders assumed that real estate would preserve its value in almost all situations thereby providing a console, which offset the risk related to lending in the subprime industry. Starting from the middle of 1990s onwards, the prices of homes seemed to be growing at a rate of 5-10% annually. They could recover a substantial amount of the loss through foreclosure because the actual worth of the principal property would have increased in case of nonpayment. The crisis within the home-financing industry results from numerous factors, which include technology, globalization, global decline in interests’ rates, and deregulation.
Graph 2 (Kemp, 2008)
Standards for Lax Lending
The rigor of lending standards has reduced, which is evident from the previous themes. The improved reception of products backed by securities implied that firms issuing loans were unlikely to stick to the risk thereby lowering their motivation to retain loan standards. Furthermore, mounting interest from financiers contributed to the boom in the lending market that had been capital controlled and therefore, incapable of meeting demand. The increasing interest also contributed to the mounting demand of investors for improved securities, in terms of production, that were possible by providing extra subprime credits. These were additionally aggregated by the prolonged appreciation of homes’ prices as well as the altered treatment of rating agency. These appeared to designate risk reports, which were largely lesser.
Those issuing credit started to settle down their prerequisites on chief measurement of loans as standards fell. The ratios of the value of the loans increased strikingly with most lenders issuing credit for 100% of the security worth. Further riskily, banks started issuing credit to clients making insignificant attempt to examine their credit background or yet earnings. In addition, state, rather than federal, governments chartered most of the principal lenders of subprime mortgages in the latest crisis. Commonly, states have weaker controls concerning lending practices as well as smaller amount of resources for monitoring creditors. Therefore, the banks could rein freely in offering subprime credit to doubtful borrowers.
Adjustable-rate Mortgages (ARMs) and Interest Rates
The ARMs emerged exceedingly famous in the United States’ mortgage industry, especially the nonprime segment just before the 1990s ended as well as throughout the middle 2000s. ARMs characterize variable amount, which is connected to the existing interest rates instead of a fixed rate of interest. Lenders started profoundly upholding ARMs as an option to customary fixed-rate mortgages in the present nonprime boom (Stanford, n.d). In addition, numerous lenders issued low introductory rates to attract new borrowers. These rates caught the attention of many nonprime borrowers thereby enticing them to take out mortgages in documentation figures.
Borrowers can benefit from ARMs if existing rates of interest reduce after origination of the credit although increasing figures can significantly raise monthly payments as well as loan rates. This is precisely what occurred in the nonprime bust. In 2003, the intended federal funds rate (FFR) reduced equally at one percent although it started going up gradually in 2004. By the middle of 2007, the rate stagnated at 5.25%; this is where it had lingered for more than a year. The increased rate left borrowers with gradually increasing payments that were unaffordable to many. The termination of teaser rates was not a relief because the artificial low amounts were restored by rates related to existing rates of interest. The monthly payments for subprime borrowers were increasing by about 50%. This is moreover motivating the rising number of negligence as well as nonpayment. However, the United States’ Federal Reserve hoping to curtail losses reduced the rates to 0.25% between September 2007 and January 2009. Rates have dropped so that in numerous situations the entire reset rate, which is indexed, goes below that of the previously fixed rate; therefore, a benefit for particular nonprime borrowers (Peterson, 2007).
An important matter concerns the “work outs.” This describes the situation whereby the lender negotiates with the borrower to circumvent reclamation as well as nonpayment. Mortgage originators used securitization process to package loans. The process is effective in moving the loan from the books of the bank to that of the investor. Nonetheless, many mortgage firms preserved the authority to charge a fee for servicing the mortgage. Eventually, the loan servicers resemble the mortgage pools’ trustee. The servicer is responsible for foreclosure as well as workout schedules that play the role of agent to the principal mortgage holder. In the arrangement, the issuer is fiduciary responsible to the holder, a duty which exists through contract where there are nonstop issues with transforming loans.
Mortgage-backed Securities and Collateralized Debt Obligations (CDOs)
Investment banks make innovations such as CDOs in which the nonpayment risk of United States’ home mortgages are widespread throughout the markets globally. Mortgage banks started to issue mortgage-backed securities (MBS) to spread their risk. These securities enabled lender to release extra resources on the firms’ balance sheets thereby enhancing the availability of additional loans as well as raising the general swiftness of their loaning commerce. This was additionally enhanced by considerable increase in investor enthusiasm as it successfully offered diversified habitual loans, extending the harm caused by nonpayment across many loans (Rogers, Powell, & Grant-Thomas, 2008).
Consequently, MBSs were ever more exploited as components in configured products, which Wall Street traded. The chief novelty of these items was that instead of spreading the threat from the loan pools uniformly across all those holding the bonds; they would spread the damage to investors with rank hierarchies depending on projected outcome. The conservative knowledge ran that investment grade loans could be formed from poor quality credit pools because of these structures.
CDOs together with MBSs were given more credit when they signed an agreement with monocline bond insurers to guarantee the assets. As a result, CDOs received the same score just like their insurer from the national credit rating agencies. This rating was similar to the one on securities that are backed by mortgages, and that of a safe municipal bond. This is because similar insurance firms assured the two types of assets. The boom in the issuances of the structured products as well as the many bondholders attracted to their high ratings made the mortgage-backed securities to gain impressive profits. Current progressions have proposed that the agencies responsible for rating may have used a special scale to groups of configured products thereby causing holders to think that the likelihood of nonpayment was considerably less than the actuality.
Many Wall Street investment banks have experienced losses and write-downs because of decreasing worth of the CDOs coupled with risky securities that are backed by mortgage. According to Paschal (2007), the total write-downs of CDOs by Wall Street would likely rise to $64 billion as reported by Citigroup Inc on 8 November 2007.
Structured Investment Vehicles (SIVs)
These are ill-balance sheet entities, which make investments in securities with high rates of debt as well as finances by giving senior capital and debt. They aim at earning a total spread amid the product of its funding costs and its asset portfolio. Senior arrears usually take the appearance of notes of medium-term as well as commercial paper. SIVs invest largely in investment-grade debt securities according to personal asset as well as portfolio frontier consented with the rating agencies. An SIV is extremely reliant on the maximum likely temporary as well as long-standing credit ratings because of its financing nature. According to Harrington (2011), the difference between SIVs and CDOs of the securities backed by assets is that the former’s portfolios are marked-to-market. On the other hand, their ratings are founded on capital models, which are according to the prerequisites of firms in charge of rating credit (Rogers, Powell, & Grant-Thomas, 2008).
Effects of Subprime Bust
The collapse of subprime mortgage industry has resulted from the high defaults from rising interests’ rates and falling home prices. Nonprime lenders were among the worst hit as the appetite of investor was quickly evaporating leaving them incapable of relieving the portfolio of swiftly degrading loans. As a result, many lenders such as New Century were broke. Additionally, the successive degradation of securities backed by nonprime such as CDO has resulted in the instability in fiscal industries around the globe. Even if nonprime mortgages are just composed of a little portion of all mortgages, the failure to pay the subprime mortgages resulted in a sequence of reactions. The nonpayment resulted in a decrease in general home prices that forced residential owners to be monetary better off to escape repaying their costly mortgages evaluated during the boom and just purchase a cheaper mortgage. As a result, individuals holding subprime-backed securities have lost enormous amounts of cash because of the nonprime boom.
The effect on fiscal industries became poorer when numerous bureaus such as Fitch reduced their ratings on vast sums worth of nonprime-linked bonds as well as CDOs. Controversy has been raised against CDOs evaluation by credit rating firms like Moody’s. Accusations have it that they have been ignoring important credit risks as well as compromising their standards of rating by offering ratings on the investment grades to CDO groups devoid of adequately establishing their modeling technique.
The bust has affected the whole United States’ housing industry in addition to the damage to lenders as well as to the holders of nonprime-backed securities. About 1.3 million mortgages were in default in 2006; this had risen by 42% from 2005. The decreased amount of nonpayment has resulted into a glut of reclaimed homes in the industry. These are reducing the prices of residential real estates across the board. The action is damaging to lenders trying to sell the houses as well as individuals holding nonprime mortgages. As the prices are falling, certain borrowers are with houses, which are not worth the loans on them. According to Shedlock (2008), the standard loan-to-loan-value fractions for numerous of the country’s leading loan issuers were 80% or more as of 31 December 2007. The circumstance known as negative equity can cause it to be inexpensive for borrowers to evade repayment than it would otherwise be for them to pay back their mortgages. As a result, the lenders can incur damage because their innovative collateral for certain mortgages is fundamentally lost. The lenders will lose the money in case they repose the house and sell it with negative equity. On January 29, 2009, Fannie Mae (FNM) announced an agreement to assist in reducing foreclosures of mortgages from their loan portfolio. Their arrangement is to collaborate with “Neighborhood Assistance Corporation of America” to re-bargain certain terms of loan so as to lower payments of interest as well as principal levels in order to assist distressed purchasers fulfill their commitments on loans (Hagerty, 2012).
Subprime meltdown has affected almost all the major international banks such as Citigroup, UBS, and Deutsche Bank AG (DB) among others.
Subprime Losers and Winners
Among the major losers include investment banks, rating agencies, mortgage firms, construction and home improvements, and discount retailers. Many big investment companies have witnessed the fall of their stock prices because of the subprime bust. The reputation of the rating agencies has deteriorated considerably because of the bust. The agencies may be forced to change their rating methods and increase control oversight.
On the other hand, some few companies have won because of the bust. These are firms with restricted exposure to subprime, mortgage-supported securities, and adjustable-rate mortgages. However, limited exposure only implies they are not losing as much cash as others. Therefore, the winners are not so because they are making any money. Sometimes the huge winners are individuals who purchased CDSs on Subprime loans to bet against the real estate bubble such as John Paulson. Examples of beneficiaries of the subprime bust include apartment REITs, financial institutions such as Wells Fargo, hedge funds, and commercial real estate investment trusts (REITs).
As mentioned earlier, nonprime lending refers to offering credit with specific credit features to individuals in need. It is a risky practice because the borrowers have a poor credit background although they are charged a premium to compensate the risk. Therefore, the two major characteristics of subprime loans include higher rates of interest and less favorable conditions to cater for the high credit risk involved. Subprime lending started because of numerous factors, which emerged in the middle of 1990s in the USA. The first sign was the increase of the outstanding debt. With time, banks as well as other lenders realized they could profit heinously from the trade of securities. The problem with subprime lending began when borrowers learned that their home value was less than the amount they were supposed to repay on their mortgage. As a result, borrowers began to avoid repayment of the loans, a move that reduced the home prices further thereby causing the meltdown on the mortgages.
The factors that motivated subprime lending include appreciation of home prices, lax lending standards, and ARMs as well as interest rates. Examples of subprime investments are CDOs and SIVs. Subprime lending has affected firms extensively with direct impact on financial firms, home-buildings as well as lenders. Some affected firms have lost whereas others have won. The losers have their reputation deteriorated and a fall in their stock prices. On the other hand, the winners have not lost much money as the losers. Therefore, subprime lending has affected the entire economy in the whole world.
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