The Subprime Market: An Overview

The subprime market is the segment of the financing business that relates to loans made to people or businesses who pose a greater risk of default because of their poor credit history or limited resources. Subprime simply means below prime or less than ideal.

Unscrupulous behavior in the subprime market for real estate was notoriously a key factor in the economic collapse of 2008-2009.

Key Takeaways

  • The subprime market makes loans available to people and businesses with flawed credit ratings.
  • Higher interest rates are charged in the subprime market to cover the increased risk of default by the debtors.
  • In the U.S., the subprime market went mainstream in the mid-1990s and was among the chief causes of the 2007-2008 financial crisis.

Understanding the Subprime Market

There is always a subprime market for loans. Lenders to high-risk individuals or businesses are able to charge substantially higher interest rates and fees to people with poor or no credit histories. A person with a damaged credit rating may take on a high-interest loan and pay it off in order to achieve a higher credit rating over time.

Subprime mortgages, subprime auto loans, and subprime credit cards all are available to many people with relatively low credit scores, but only at higher interest rates to compensate lenders for the additional payment default risk.

The subprime market is a profitable one for lenders as long as most of their borrowers can repay their loans most of the time. Subprime lending is less susceptible to interest rate swings because subprime borrowers don't have the option to refinance their debts unless and until their credit ratings improve.

The health of the subprime market is, however, highly dependent on the strength of the overall economy. When jobs dry up and financial pressures build, more people default on their loans. Even subprime lenders avoid taking excessive credit risks.

History of the Subprime Market

The subprime market in the U.S. existed mainly on the fringes until the mid-1990s when established banks and specialized lenders realized the profits to be made from relaxing their lending standards to help those with low or no credit scores to buy a house, a car, to start a business, or to get a college degree.

Drawn by higher interest margins, lenders expanded their conventional loan operations to accommodate this growing market. For most traditional lenders, this simply meant offering loan products at varying rates depending upon the creditworthiness of the applicant.

The Secondary Market for Debt

The practice became even more attractive when lenders considered that they could package their loans and sell them in bulk to institutional investors, who then marketed them as investment products.

This was not a new practice. Mortgage lenders typically sell their loans at a slight discount to other businesses. The new owner takes on the chore of collecting the mortgage payments and the lender recoups the investment and frees up money to make new loans.

The system worked until 2008 when the housing bubble burst.

The Subprime Crisis

In the early 2000s, housing prices grew relentlessly, drawing more and more buyers and speculators into frenzied bidding wars. Meanwhile, existing homeowners were encouraged to take out home equity loans, borrowing money against the inflated values of their homes.

Lenders relaxed their standards, assuring themselves and their customers that they couldn't lose money on real estate. Prices hit their peak in 2006 and, by 2008, the bubble began to burst.

By that point, the lenders of all of those mortgages had sold them on. They had been packaged or securitized as products and resold to Wall Street investors.

Many of those packages contained subprime mortgages. The people who took out those mortgages defaulted or walked away from homes that were no longer worth what they had paid for them. The last buyers were left holding worthless paper on mortgages in default.

The Blame Game

Those seen as the villains in the financial crisis include: banks with lax or no lending standards who were eager to collect loan origination fees; regulators at the Federal Reserve Board and the Securities and Exchange Commission (SEC) asleep at the switch; and credit agencies eager to sign off on securitized offerings to collect rating fees. Responsibility also falls on those who borrowed far beyond their means to buy houses they couldn't afford.

The subprime crisis led to a series of new laws, including the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Housing and Economic Recovery Act that aimed at patching the disastrous effects of the meltdown and preventing another one from occurring.