Monday, 6 October 2008

What is Subprime Lending?

Lehman collpased. HBOS (Halifax Bank Of Scotland) and Merrill Lynch sold out. AIG in doldrums. The recent news of the global financial crisis made me open google and explore about the reasons, which knocked down these titans. As far as I could understand the primary reason for the Lehman's demise was Subprime Lending. Since that term was gibberish to me I did another google search to find out the meaning of that. Here is what I could understand.

Everyone and anyone in this world is in need of extra funds at some point in time. It may be for buying a house, buy an HDTV, a car etc. Suppose, I need to buy a house. Since a house is a pretty big investment, I don't think I can afford to make a down payment of the entire cost. So I look for a financial institution, which can give me a loan as per my financial eligibility or credit score. The credit score is a key factor to determine
  • Whether or not I am eligible for a loan?
  • If I am, then what would be the loan amount?
  • What would be the interest rate on the loan?

Now if my credit score is below than the minimum required by the lending institution then I would be denied a loan. So I have been denied a Prime Lending.

I would look for another institution like Lehman, which is willing to lend to me even with my low credit score. This is called Subprime Lending (Since in this case my house would be mortgaged until I pay back the entire loan amount, it would be called Subprime Mortgage Lending). Of course, I would be charged a higher rate of interest for the loan amount because I am a Subprime Borrower and as per my credit score I have higher risk of defaulting. Besides sub-prime lending rates are also higher because more applications are rejected and marketing costs are higher.

Some subprime lenders are independent but mostly they are affiliates of the mainstream lenders functioning under different names.

Subprime market has made mortgages (and home ownership) available to a segment of the population that otherwise would have been shut out of the market, which is a positive development. The bad part is that some borrowers who are eligible for loans from mainstream lenders end up in the subprime market. They are prime borrowers but they pay subprime prices.

This happens partly because of the difficulties some borrowers face in determining whether or not they qualify in the mainstream market. The main reason some prime borrowers end up paying sub-prime prices is that they are solicited by subprime lenders and go along with the deal pitched to them without ever contacting a mainstream lender. This is referred to as "steering".

I guess thats enough for the definition of Subprime Lending. In case you have any queries, you can always shoot them to