Sub Prime Lending

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What is Sub-Prime Lending ?

Subprime Lending (also known as B-paper, near-prime, or second chance lending) is lending at a higher rate than the prime rate. However, the term "subprime" does not actually refer to interest rate on loans, but  refers to the credit status of the borrower (being less than ideal),  Thus, we can say that a Subprime Lending refers to granting of loans to subprime borrowers i.e., borrowers with low credit scores.   Such borrowers normally do not qualify for loans at the normal market interest.    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 the loans granted to top rated borrower,  due to the increased risk. 

Subprime lending encompasses a variety of credit instruments, including subprime mortgages,   subprime credit cards and subprime car loans etc.

Subprime lenders :

To increase their share in the financial sector,  lenders often take on additional risks associated with lending to people with poor credit ratings. Subprime loans are considered to carry a far higher  risk for the lender due to the aforementioned credit risk characteristics of the typical subprime borrower.  In the case of many subprime loans, the additional risk is compensated  with a higher interest rate (higher risk, higher reward).. In the case of subprime credit cards,  a subprime customer (i.e. credit card holder) is charged higher late fees, higher over limit fees, yearly fees, or up front fees for the credit card issued to him.  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. .

Subprime borrowers :

Subprime offers an opportunity for borrowers with a less than ideal credit record to at least gain access to credit.  Borrowers  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. 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 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 mortgage loans have a much higher rate of default than prime mortgage loans and are priced based on the risk assumed by the lender.

SubPrime Mortgage Crisis :

The Reasons for SubPrime or How This Bubble was Built:

The genesis of the present subprime mortage crisis is deep rooted.  Traditionally, banks used to  finance their mortgage lending through the deposits they receive from their customers. Thus they could lend against mortgage only to a limited extent i.e. the additional deposits they could collect.    However, in recent years, banks have adopted newer and complex  models,  where they sell on the mortgages to the bond markets.  This  has also led to abuses as banks no longer have the incentive to check carefully the mortgages they issue.

Traditionally, the risk of default (called credit risk) was assumed by the bank originating the loan. However, owing to innovations in securitization, credit risk is now shared more broadly with investors, because the rights to these mortgage payments have been repackaged into a variety of complex investment vehicles, generally categorized as MBS (Mortgaged Backed Securities)  or CDO (Collateralised debt Obligations) 

Securitization is a structured finance   process in which assets, receivables or financial instruments are acquired, classified into pools, and offered as collateral  for third-party investment.   There are many parties involved. Due to securitization, investor appetite for mortgage-backed securities (MBS), and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others.  Alan Greenspan stated that the securitization of home loans for people with poor credit — not the loans themselves — were to blame for the current global credit crisis.

A CDO, essentially, is a repacking of existing debt, and in recent years MBS collateral has made up a large proportion of issuance. In exchange for purchasing the MBS, third-party investors receive a claim on the mortgage assets, which become collateral in the event of default. Further, the MBS investor has the right to cash flows related to the mortgage payments. To manage their risk, mortgage originators (e.g., banks or mortgage lenders) may also create separate legal entities, called special-purpose entities (SPE), to both assume the risk of default and issue the MBS. The banks effectively sell the mortgage assets (i.e., banking accounts receivable, which are the rights to receive the mortgage payments) to these SPE. In turn, the SPE then sells the MBS to the investors. The mortgage assets in the SPE become the collateral.

Another reason for the curent crisis is the role of mortgage brokers.  These brokers  don't lend their own money. There is not a direct correlation between loan performance and compensation. They have big financial incentives for selling complex, adjustable rate mortgages (ARM's), since they earn higher commissions.   According to a study by Wholesale Access Mortgage Research & Consulting Inc., in 2004 Mortgage brokers originated 68% of all residential loans in the USA, with subprime and Alt-A loans accounting for 42.7% of brokerages' total production volume. The chairman of the Mortgage Bankers Association claimed brokers profited from a home loan boom but didn't do enough to examine whether borrowers could repay.

Yet another reason that led to the current crisis is the role of mortgage underwriters.   Underwriters determine if the risk of lending to a particular borrower under certain parameters is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit, capacity and collateral.   In 2007, 40 percent of all subprime loans were generated by automated underwriting.  An Executive vice president of Countrywide Home Loans Inc. stated in 2004  "Prior to automating the process, getting an answer from an underwriter took up to a week. We are able to produce a decision inside of 30 seconds today. ... And previously, every mortgage required a standard set of full documentation. Some think that users whose lax controls and willingness to rely on shortcuts led them to approve borrowers that under a less-automated system would never have made the cut are at fault for the subprime meltdown

The role of credit rating agencies are also  under scrutiny for giving investment-grade ratings to securitization  transactions which were actually  holding subprime mortgages.   Higher ratings are theoretically due to the multiple, independent mortgages held in the MBS per the agencies, but critics claim that conflicts of interest were in play.

Present Situation :

The subprime mortgage crisis is an ongoing problem manifesting itself through liquidity issues in the banking system owing to foreclosures  which accelerated in the USA  in late 2006 and triggered a global financial crisis during 2007 and 2008. The crisis began with the bursting of  the US housing Buddle  and high default rates on "subprime"  and other Adjustable Rate Mortgages  (ARM) made to higher-risk borrowers  with lower income or lesser credit history  than "prime" borrowers. Loan incentives and a long-term trend of rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favorable terms later. However, once housing prices started to drop moderately in 2006-2007 in many parts of the U.S, refinancing became more difficult. Defaults and foreclosure activity increased dramatically as ARM interest rates reset higher. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% versus 2006.The Economist estimated in December, 2007, that subprime defaults would reach a level between U.S. $200-300 billion.

Impact / Likely Impact of the Crisis  :

• The property crash is likely to impact the  broader economy of USA as  the building industry is expected to cut its output by half, resulting in  loss of between one and two million jobs.
• Many smaller builders are likely to  go out of business, and the larger firms are likely to  suffer huge losses.
• The building industry makes up 15% of the US economy,.  A slowdown in this sector will surely  hits many other industries, for example, makers of durable goods, such as washing machines, and DIY stores, such as Home Depot.
• Economists expect the US economy to slow in the last three months of 2007 to an annual rate of 1% to 1.5%. However,  no one is sure how long the slowdown will last. Many US consumers have spent beyond their current income by borrowing on credit, and the fall in the value of their homes may make them reluctant to continue this pattern in the future.
• Bankers are likely to cut down on their credit targets    They are already rejecting credit cards applications, insisting  for higher  deposits for house purchase, and stringent norms for personal loans.
• The mortgage market has been particularly badly affected, with individuals finding it very difficult to get non-traditional mortgages, both sub-prime and "jumbo" (over the limit guaranteed by government-sponsored agencies).
• The banks have been forced to do this by the drying up of the wholesale bond markets and by the effect of the crisis on their own balance sheets
• The banking industry is facing huge losses as a result of the sub-prime crisis.
• Already banks have announced billions of  worth of losses as many of the mortgage bonds backed by sub-prime mortgages have fallen in value.  The losses could be much greater, as many banks have concealed their holdings of sub-prime mortgages in exotic, off-balance sheet instruments such as "structured investment vehicles" or SIVs.
• Although the banks say they do not own these SIVs, and therefore are not liable for their losses, they may be forced to cover any bad debts that they accrue
• Also suffering huge losses are the bondholders, such as pension funds, who bought sub-prime mortgage bonds.  These have fallen sharply in value in the last few months, and are now worth between 20% and 40% of their original value for most asset classes, even those considered safe by the ratings agencies.
• If the banks are forced to reveal their losses based on current prices, they will be even bigger.  It is estimated that ultimately losses suffered by financial institutions could be between $220bn and $450bn, as the $1 trillion in sub-prime mortgage bonds is revalued.

Impact / Likely Impact of the Crisis on Indian Markets   :

Indian Banks have only limited exposure to US subprime maket.   Therefore, directly Indian banking industry or Indian businessmen are not likely to have big hits.  However, as now markets are integrated and Indian markets are also affected due to international developments, capital market in India have witnessed huge volatility.  The forex market has also witnessed turmoil leading to losses of many corporate and banks in India who had taken speculative derivative positions.   In August, 2007,  panic withdrawal of funds took place which triggered fall in the Indian markets, but soon they were able to recover.   .Therefore, we can sum up saying that Indian markets too will remain volatile due to subprime crisis.