Summary
Subprime loans are the root cause of the country's current economic and financial problems. In order for the country's financial problems to be corrected, the problems with these loans will have to be resolved. Resolution of these problems involves structuring loans that can be paid by the borrowers and that provide some return for the lenders.
Analysis
A Primer on Subprime Mortgage Loans, Subprime Lenders, Alt-A Mortgage Loans,
Alt-A Mortgage Lenders, Subprime Credit Cards, and Subprime Car Loans
Subprime Mortgages
It is universally desirable to own a home.
Homeownership is the financial foundation of the economy, and the
personal financial foundation of most people.
Several years ago, in order to increase the level of homeownership in the
country, mortgage lenders began making mortgage loans to borrowers who had less
than perfect credit histories or who were new to the credit market. Because of the increased risk present in
these loans, they have been referred to as “subprime” mortgage loans.
Subprime mortgage loans refer to mortgage loans made to borrowers who have a
less than prime credit condition. This less than prime credit condition may be
due to a history of past credit or financial problems or simply be reflective
of the fact that a person may be new to the world of credit and not have
established a credit history.
Borrowers with credit scores of 600 and below (650 and below, by some
definitions) often will find a subprime mortgage as their only source of
mortgage financing. Late payment of bills or declaring bankruptcy could very
well place borrowers in a situation where they can only qualify for a subprime
mortgage. Accordingly, it is often advisable for people with low credit scores
or temporary credit problems to wait for a period of time and build up their
credit scores before applying for a mortgage in order to insure they are
eligible for a conventional mortgage.
There are other factors that may cause a borrower to fall into the subprime
category. For example, some borrowers might be classified as subprime despite
having an excellent credit history because they choose not to provide the
lender with the opportunity to verify their income or assets stated in the loan
application process. Loans of this type are called “stated income” loans or
"stated asset" (SISA) loans or "no income-no asset" (NINA)
loans. Due to a subprime lender’s
perceived higher risk in making these types of loans, the borrower is
considered a subprime credit.
Subprime lenders generally regard subprime lending as a "numbers
game" where they have to go through many prospective borrower applications
in order to weed-out unacceptable risks and determine which applicants
represent an acceptable level of risk.
In order to deal with the large number of applications, subprime lenders
often will use a credit scoring system to determine which applicants are
acceptable risks and for which loan programs they may qualify.
In addition to using credit scoring programs to help them sort out the many
applications that they receive for subprime loans, subprime lenders often make
extensive use of television and Internet advertising to help bring in subprime
loan applications. Also, subprime
lenders buy lists of potential subprime borrowers and solicit their business by
mail or over the Internet.
The reason that subprime lenders go to the trouble of examining large
numbers of applications and determining which ones represent acceptable levels
of risk is that subprime lenders charge higher interest rates and fees than
those charged for non-subprime mortgage loans.
As of the first half of 2007, approximately 25% of mortgage originations in
the
Subprime mortgage loans tend to have a shorter time horizon and fewer
opportunities to refinance when interest rates fall than do traditional
non-subprime loans.
Alt-A Mortgage Loans
Alt-A mortgage loans are considered to be of a higher quality than subprime
mortgage loans but not as high quality as a prime mortgage loan that would
qualify for sale to Fannie Mae or Freddie Mac.
They can share many structural qualities with subprime loans, but the
pricing of Alt-A loans is generally somewhat more favorable to a borrower than
that of a subprime loan.
Examples of a typical Alt-A borrower would be one who has an acceptable
credit rating but may have trouble verifying income, employment, or assets.
Subprime Mortgage Payment Reset Concerns
The greatest concern regarding subprime mortgages is that the vast majority
of them are adjustable rate loans that start out with low "teaser"
interest rates or low “teaser” monthly payment amounts that typically expire
after the first year or two.
When this "teaser" period expires, the interest rate or payment
amount can increase, often resulting in the subprime mortgage borrower being
placed in the position of being unable to make the new monthly payments. The
typical results are:
1. The subprime lender has to foreclose on the subprime mortgage, or
2. The subprime lender has to enter into a workout arrangement with the
borrower which usually results in the subprime lender writing down the value of
the loan on their books.
In either of these two possibilities, the subprime lender winds up with an
investment value that is less than what was reflected on their books before the
subprime loan went into default.
Subprime Car Loans
There are estimates that approximately $50 billion in subprime car loans
were originated in 2006, the most recent year for which reliable information is
available. This accounts for over 19% of
all car loans originated during that period.
Subprime car loans include some features that make them as risky as subprime
mortgage loans, and some features that make them less risky. For example, mortgage loans are secured by an
asset that generally appreciates in value, whereas a car loan is secured by an
asset that generally depreciates in value.
On the other side of the ledger, mortgage loans are often repaid based
upon a variable interest rate and variable payment amount; whereas car loans
are more likely to be on a fixed rate and fixed payment amount.
Comparing subprime car loans to prime car loans, we find that subprime car
loans are usually repaid over a longer term, require a lower down payment, and
are made for a higher loan-to-value ratio than are prime car loans.
In the final analysis, it is believed that subprime car loans carry slightly
less risk than do subprime mortgage loans since the retention of the car is
often critical in order for the borrower to continue to work. Even so, there is always the possibility that
the borrower could walk away from the car and subprime car loan and obtain
transportation through another subprime car loan arrangement.
Subprime Credit Cards
Many of the issues of subprime mortgage lending apply as well to subprime
credit cards. Today, about 20% of the credit cards issued in the
Today, the credit card industry divides customers into the "prime"
and "subprime" markets. Borrowers with a credit score in the top tier
(and these tiers vary from lender to lender and are adjusted from time to time)
may receive a credit card with a line of credit at an interest rate around
12%. Borrowers with a slightly lower
credit score may receive a credit card with a line of credit at an interest
rate of 15%, and a borrower with an even lower credit score may receive a
credit card with a credit line at an interest rate around 17%. These are all
considered non-subprime credit card customers.
Interest rates on subprime credit cards can be anywhere in a range from 20%
to as high as 35% or so, depending upon the credit history of the
borrower. In addition, lenders charge
various fees, such as an annual fee and an account maintenance fee, to help
offset their increased risk.
Subprime credit card lending began in the 1990s to allow subprime lenders to
provide credit cards to customers with less than perfect credit and profit from
the higher interest rates and fees that subprime lenders charge for these
credit cards. The subprime credit card industry's market goal was to provide a
credit card with a line of credit to customers with credit scores in the 500s,
little or no credit history, those coming out of a personal bankruptcy and
anyone else with a recent history of credit or financial problems.
Subprime credit cards offered to subprime borrowers typically require no
security deposit, as do secured credit cards. Credit limits start out very low
compared to those in the non-subprime credit card industry, typically in the
$100 to $500 credit limit range. Fees and interest rates are much higher than
those for non-subprime credit cards. Likewise, the effect of some terms can be
magnified due to the small credit line size. For example, take an overlimit fee
of $29.00. This fee is of course a much greater percentage for a subprime
credit card line of $500 than it would be for a non-subprime credit card of
$5,000.
With these greater rewards for subprime credit card lenders come greater
risks. It is reported that subprime credit card companies are writing off
losses in the 15% to 17% range versus the average industry loss rate of 6.5%,
according to CardWeb; and delinquency rates for subprime card companies average around 10% while
those for the rest of the lending industry average around 5%.
Subprime credit card issuers use mass marketing techniques to bring in
customers. Mail and Internet new account solicitations exceeded 5 billion in
2006, and were up dramatically from the total in 2005.
Secured Subprime Credit Cards
Those with the lowest credit scores and histories may still qualify for a
secured subprime credit card. Essentially, even though a secured subprime
credit card looks and, in terms of making purchases, acts like a regular credit
card, it is basically a pre-paid card wherein the customer makes a
"security deposit" to insure the payment of charges made with the
secured subprime credit card.
Actually, the term "subprime" is typically not included in the
term of art when discussing secured credit cards; but make no mistake about it,
one only has to take a look at the terms of a secured credit card to see that
it is a subprime credit card. Typical secured credit card terms include a hefty
(in relation to the “credit line”) annual fee and require a minimum deposit of
from $99 up to $5,000 depending upon the size of the “credit line” granted.
Despite their onerous terms, often a secured credit card is used as the
first step for someone who needs to reestablish their credit.
Debit Cards
Debit cards carry the Visa or MasterCard name and give you the privilege of
seeing money fly out of your checking account as soon as you make a purchase.
In this way, a debit card is similar to a secured credit card except that the
secured credit card essentially pays for purchases from the deposit you made
earlier to fund the secured card.
Managing a debit card that really does not offer you any credit, and
coordinating all of the purchases that you make with your debit card with all
of the checks that you write is a management nightmare.
Banks love debit cards because they eliminate the float that customers
generally enjoy between the time a purchase is made and the time that the
purchase has to be paid for, i.e., when you pay your credit card bill.
The problems that have resulted from the origination of a large amount of subprime loans have caused enormous problems for the economy and financial markets of the United States as well as for many other countries. In order for the problems with these loans to be resolved, realistic underwriting standards must be applied that will result in workable loans that borrowers can afford and that will provide a return to the lenders.
This is not an easy task to accomplish, but it can and must be done.
