What is Subprime? and Subprime Crisis
Definitions of SubPrime on the Web:
Credit with higher risk characteristics, such as bankruptcy or collection accounts.
www.closenow.com/glossarys.htmlA term referring to borrowers with a less-than-perfect credit history, also called B&C credit.
www.guarantybanking.com/glossary_l.aspxIndustry term used to describe credit and loan products that have less than stringent lending and underwriting terms and conditions. As a result of the higher risk, subprime products charge a higher rate of interest.
www.amdreammortgage.com/glossary.phpSubprime lending
(also known as B-paper, near-prime, or second chance lending) is the practice of making loans to borrowers who do not qualify for the best market interest ratescredit history. The phrase also refers to banknotes taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and certain types of self-employed persons. because of their deficient
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 A-paper loans due to the increased risk. Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others. The term "subprime" refers to the credit status of the borrower (being less than ideal), not the interest rate on the loan itself.
Subprime lending is highly controversial. Opponents have alleged that subprime lenders have engaged in predatory lending practices such as deliberately lending to borrowers who could never meet the terms of their loans, thus leading to default, seizure of collateral, and foreclosure. There have also been charges of mortgage discrimination on the basis of race.[1] Proponents of subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market.[2]
The controversy surrounding subprime lending has expanded as the result of an ongoing lending and credit crisis both in the subprime industry, and in the greater financial markets which began in the United States. This phenomenon has been described as a financial contagion which has led to a restriction on the availability of credit in world financial markets. Hundreds of thousands of borrowers have been forced to default and several major American subprime lenders have filed for bankruptcy.
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 [1]
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 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 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. About 21 percent of all mortgage originations from 2004 through 2006 were subprime, up from 9 percent from 1996 through 2004, says John Lonski, chief economist for Moody's Investors Service. Subprime mortgages totaled $600 billion in 2006, accounting for about one-fifth of the U.S. home loan market.
There are many different kinds of subprime mortgages, including:
- interest-only mortgages, which allow borrowers to pay only interest for a period of time (typically 5–10 years);
- "pick a payment" loans, 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 initial fixed rate mortgages that quickly convert to variable rates.
This last class of mortgages has grown particularly popular among subprime lenders since the 1990s. Common lending vehicles within this group 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. The new interest rate is typically set at some margin over an index, for example, 5% over a 12-month LIBOR. Variations on the "2-28" include the "3-27" and the "5-25".
Subprime mortgage crisis
Beginning in late 2006, the U.S. subprime mortgage industry entered what many observers have begun to refer to as a meltdown. A steep rise in the rate of subprime mortgage 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.[10] The failure of these companies has caused prices in the $6.5 trillion mortgage backed securities market to collapse, threatening broader impacts on the U.S. housing market and economy as a whole. The crisis is ongoing and has received considerable attention from the U.S. media and from lawmakers during the first half of 2007.[11][12]
However, the crisis has had far-reaching consequences across the world. Sub-prime debts were repackaged by banks and trading houses into attractive-looking investment vehicles and securities that were snapped up by banks, traders and hedge funds on the US, European and Asian markets. Thus when the crisis hit the subprime mortgage industry, those who bought into the market suddenly found their investments near-valueless. With market paranoia setting in, banks reined in their lending to each other and to business, leading to rising interest rates and difficulty in maintaining credit lines. As a result, ordinary, run-of-the-mill and healthy businesses across the world with no direct connection whatsoever to US sub-prime suddenly started facing difficulties or even folding due to the banks' unwillingness to budge on credit lines.
Observers of the meltdown have cast blame widely. Some have highlighted the predatory[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. Borrowers have also been criticized for entering into loan agreements they could not meet.[14] practices of subprime lenders and the lack of effective government oversight.
Many accounts of the crisis also highlight the role of falling home prices since 2005. As housing prices rose from 2000 to 2005, borrowers having difficulty meeting their payments were still building equity, thus making it easier for them to refinance or sell their homes. But as home prices have weakened in many parts of the country, these strategies have become less available to subprime borrowers.[15]
Several industry experts have suggested that the crisis may soon worsen. Lewis "Lewie" Ranieri, formerly of Salomon Brothers, considered the inventor of the mortgage-backed securities market in the 1970s, warned of the future impact of mortgage defaults: "This is the leading edge of the storm. … If you think this is bad, imagine what it's going to be like in the middle of the crisis."[16] Echoing these concerns, consumer rights attorney Irv Ackelsberg predicted in testimony to the U.S. Senate Banking Committee that five million foreclosures may occur over the next several years as interest rates on subprime mortgages issued in 2004 and 2005 reset from the initial, lower, fixed rate to the higher, floating adjustable rate or "adjustable rate mortgage".[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 credit than subprime borrowers at not quite prime rates.[18]
Some economists, including former Federal Reserve Board chairman Alan Greenspan, have expressed concerns that the subprime mortgage crisis will affect the housing industry and even the entire U.S. economy. In such a scenario, anticipated defaults on subprime mortgages and tighter lending standards could combine to drive down home values, making homeowners feel less wealthy and thus contributing to a gradual decline in spending that weakens the economy.[19]
Other economists, such as Edward Leamer, an economist with the UCLA Anderson Forecast, doubts home prices will fall dramatically because most owners won't have to sell, but still predicts home values will remain flat or slightly depressed for the next three or four years.[20]
In the UK, some commentators have predicted that the UK housing market will in fact be largely unaffected by the US subprime crisis, and have classed it as a localised phenomenon.[21]Northern Rock, the UK's fifth largest mortgage provider, had to seek emergency funding from the Bank of England, the UK's central bank as a result of problems in international credit markets attributed to the sub-prime lending crisis. However, in September 2007
As the crisis has unfolded and predictions about it strengthening have increased, some Democratic lawmakers, such as Senators Charles Schumer, Robert Menendez, and Sherrod Brown have suggested that the U.S. government should offer funding to help troubled borrowers avoid losing their homes.[22] Some economists criticize the proposed bailout, saying it could have the effect of causing more defaults or encouraging riskier lending.
On August 15, 2007, concerns about the subprime mortgage lending industry caused a sharp drop in stocks across the Nasdaq and Dow Jones, which affected almost all the stock markets worldwide. Record lows were observed in stock market prices across the Asian and European continents.[23] The U.S. market had recovered all those losses within 2 days.
Concern in late 2007 increased as the August market recovery was lost, in spite of the FedSeptember 18 and by a quarter point (0.25%) on October 31. Stocks are testing their lows of August now. cutting interest rates by half a point (0.5%) on
On December 6, 2007, President Bush announced a plan to voluntarily and temporarily freeze the mortgages of a limited number of mortgage debtors holding ARMs by the Hope Now Alliance. He also asked members Of Congress to: 1. Pass legislation to modernize the FHA. 2. Temporarily reform the tax code to help homeowners refinance during this time of housing market stress. 3. Pass funding to support mortgage counseling. 4. Pass legislation to reform Government Sponsored Enterprises (GSEs) like Freddie Mac and Fannie Mae.[24]
Sources:
http://en.wikipedia.org/wiki/Subprime
