- Real Estate
What Exactly Is a Subprime Loan
Nowadays, everyone is talking about the subprime loan crisis as if the term "subprime loan" is so obviously understood that it needs no further explanation. The general assumption is that it means "bad loans." Of course, this makes the banks that took part in the subprime loaning business to appear as fools. After all, why would you loan to someone who can't afford to pay it back?
The purpose of this hub is to figure out what exactly the term really means and incidentally, why did all of America's most prominent institutions gets involved with the practice of subprime loans?
What is a Subprime Loan?
Interestingly, the term subprime does not have an exact meaning. For all purposes, it refers to the practice of giving loans to people who would not normally qualify for a loan. Interestingly, it only took on this meaning as recently as 1993 according to the Oxford Dictionary.
What does it mean to qualify for a loan.
As anyone who's applied for a loan knows, a person qualifies for a loan based on a credit score. The would-be borrower enters their financial information into an application and a score is computed.
The most popular credit score in the United States is the FICO score. This stands for the Fair Isaac Corporation Score. Fair Isaac is the company that devised the FICO score and its name comes from its founders Bill Fair and Earl Issac.
So, the meaning of a subprime loan is a loan that is made to someone who has a FICO score that is lower than the recommended prime score. In other words, it is someone who doesn't qualify for a conventional loan.
FICO scores by their nature are meant to assess the probability that a borrower will default on their loan. The exact formula for the FICO is not public. The score ranges from 300 to 850 with the majority of people between 600 and 800. The higher the score, the better.
A score above 700 is considered a good score. A score below 600 is considered a bad score. This score is calculated based on your credit history and based on the ratio of credit used to credit available.
Subprime loans are loans to people whose FICO score is too low to qualify for the best interest rate. In exchange for accepting greater risk, the lender charges a higher interest rates.
How high should the interest rate be? How high should fees be related to these loans? A lending practice that is excessive is called "predatory lending." Dozens of states have passed statutes in the effort to stop predatory lending.
The Rapid Growth of Subprime Loans
According to USA Today, the subprime mortgage activity had been rapidly growing before the crisis. From 1994 to 2003, there was an average of 25% a year growth. In 2003, it was a $330 billion dollar business.
The reason for this growth was the creation of the credit default swap market. The credit default swap was invented in 1997 by JPMorgan Chase. This allowed nonprime lenders to mitigate risk by selling off the risk. The result was that there was a significant growth in subprime loans as well as the credit default swap market.
By 2007, the Credit Default Swap Market had reached $45 trillion in valuation.
Credit Default Swaps and the Subprime Crisis
The major reason for the sudden growth in Credit Default Swaps was the deregulation of the financial sector. The Commodity Futures Modernization Act of 2000 allowed banks to offer futures contracts without regulation by the federal government.
This act enabled in a dramatic growth of credit default swaps which ultimately resulted in the bankruptcies of the major financial houses.
Although the risk of defaults has historically been very low, a series of defaults was devastating to the financial sector.