- Summarize the concept of subprime loans and the risks they pose to the lender and borrower.
Americans have been sold on the idea of owning a home as one of the ultimate goals for every working family…part of the “American dream”. Even if not at the family stage, owning a home is a decent and commendable achievement regardless of your stage in life. During the early years of 2000s, banks and other lending institutions were awash with ‘goodwill’ and it appears anybody who required a mortgage was not turned away. The housing mortgage market rose dramatically, but the fall experienced in the middle of the decade was equally dramatic due to excessive use of tricky lending programs called subprime mortgages by brokers and other lending institutions. Lenders appeared not to worry too much about borrowers’ credit ratings and as a result many borrowers with low credit ratings were nevertheless targeted by the lenders and given mortgages. Myers (2008) states that “such loans quickly became big business, as the subprime loan market grew from $35 billion in 1994 to $665 billion in 2005, and that between 1998 and 2006, lenders loaned more than $2 trillion in subprime home loans”.
Brooks & Simon (2007) state that ‘subprime’ generally refers to the credit rating of the borrower; those whose credit score is below 620 on a scale of roughly 300 to 850. “During the housing boom, many who could have qualified for a traditional home loan instead took out a subprime loan, partly due to aggressive mortgage broker tactics, such as approving loans more easily, shoddy documentation or not fully explaining stricter repayment terms”. This tactic was called ‘predatory lending’. Demyanyk & Hermet (2008) provided evidence that the rise and fall of the subprime mortgage market followed a classic lending boom-bust scenario, in which unsustainable growth lead to the collapse of the market; and they referred to these borrowers as ‘high Loan-to-Value (high-LTV) and related the rise in adjusted delinquency and foreclosure rates to the increasing riskiness of high-LTV borrowers.
This boom-bust scenario is what Bianco (2008) referred to as a housing bubble; “an economic bubble that occurs in local or global real estate markets defined by rapid increases in the valuations of real property until unsustainable levels are reached in relation to incomes and other indicators of affordability. Rapid decreases in home prices and mortgage debt that are higher than the value of the property then follow”. Such bubbles are normally identified after a market correction.
Myers (2008) lists the following provisions that comprise of subprime loans: “teaser loans, adjustable rate mortgages (ARMs), balloon payment provisions, negative amortization provisions, piggyback provisions, and loans requiring no documentation, known colloquially as ‘liar loans’. Such loans quickly became big business, as the subprime loan market grew from $35 billion in 1994 to $665 billion in 2005. Between 1998 and 2006, lenders loaned more than $2 trillion in subprime home loans”.
Subprime loans posed several risks to lenders: possibility of default by borrowers, loss of capital, loss of reputation, loss of income stream and complete bankruptcy of the lender (More than 25 subprime lenders declared bankruptcy, with some closing down such as Ameriquest). The loans also posed risks to borrowers: loss of home equity, loan default, foreclosure, possibility of inflated property taxes, risk of bankruptcy, a tarnished credit score, lost reputation, risk of homelessness after foreclosure, and disrupted family life.