11 Aug 07 What is Subprime Mortgage Lending?
Most investors know that the cause of the current market collapse is the Subprime mortgage lending crisis in the US market. However, many investors are not sure what exactly subprime mortgage lending is. Subprime mortgage lending refers to the practice of offering housing mortgage loans to people who do not qualify for the normal housing mortgage loans. When it comes to approving a mortgage loan, banks take into account the repaying capacity of the borrower and his credit history. If a person has a low credit score, it means he is not creditworthy for a normal mortgage loan (also known as prime mortgage). To target such individuals sub prime mortgage lending was introduced. As we know, if the risk is more, banks attach a higher risk premium and hence the interest rate is also higher. Because of the higher interest rates, banks were working on a higher spread and hence the net interest margin of banks active in sub prime mortgage lending was higher. The subprime mortgage lending crisis began with a series of defaults by borrowers who were offered loans at higher interest rates because of their lower repayment capacity. This was a double whammy. First of all, the borrowers who were offered subprime mortgages had a poor credit history and then the higher interest rates charged only increased the burden on these borrowers and made it tougher for them to honour their mortgages, even if they had the intention to do so. This caused a series of defaults which is now commonly known as the subprime mortgage lending crisis.
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To add to your post, In the US the lenders started what is called “Predatory lending” practices to the sub prime borrowers, new exotic varieties of mortgage products like Option ARMs were cooked by these lenders. To illustrate in one variety of these mortgage products the lender would offer a introductory 1% interest to the borrower in the first year of the loan, or for the first year the borrower would have to pay only the interest part of the mortgage that too only partially, as a result unsophisticated sub prime borrowers made costly mistakes and took decisions to take mortgage loans they could have never afforded, after the initial year or so when the loan installment started going up sharply (2,3,4 times in many cases) the borrowers started defaulting on the loans, and hence this whole mess.
In the US the mortgage lenders sell their mortgages as securities on wall street and US being the financial superpower financial institutions from across the world puts money in it. Nobody realized that the assets behind those mortgage backed securities were such risky mortgages and this is how the whole chaos spread across the world. Even now we don’t know exactly which banks and FIs are affected.
@Abhinav – Hi Abhinav, thanks for your informative insights