What is the Subprime Market
The subprime market serves individuals with questionable or limited credit histories who borrow for houses, cars, and other general purchases. Subprime means "below" prime, a designation for borrowers with normal or credit histories in good standing. Subprime mortgages, subprime auto loans and subprime credit cards are issued to these individuals with low credit scores at higher interest rates to compensate lenders for additional payment default risk.
BREAKING DOWN Subprime Market
The subprime market can be a profitable one for lenders as they can demand higher interest rates, and as long as borrowers are able to repay their loans. Subprime lending is also less susceptible to interest rate swings because subprime borrowers usually don't have the option to refinance debt until their credit rating improves. The health of the subprime market is highly dependent on the strength of the overall economy; if people can generally find work and earn a decent wage, they are more likely to repay their debts. Subprime lending can dry up very fast in a weakening economy, as lenders collectively will avoid taking excess credit risks.
History of the Subprime Market
The subprime market originated around the mid-1990s to enable those with low or no credit scores to participate in the "American dream" of buying a house, owning a car, starting a business or sending a child to college. Drawn by fat interest margins, banks and specialized lenders expanded their conventional loan operations to accommodate this growing market. But with greater profitability comes higher payment defaults, as these subprime loans generally go to borrowers on the lower rungs of the economic ladder who experience fluctuations in income.
The growth rate of the subprime market topped out in the mid-2000s, particularly in subprime mortgages. When Wall Street got its hands on the billions of subprime mortgages to package up, securitize and sell to the unsuspecting, uncaring or uninformed public, the subprime credit crisis entered an accelerated phase. Rewinding the horror film tape, it can be seen that many others were responsible for the financial and economic disaster that unfolded.
Banks with lax or no lending standards eager to collect loan origination fees, regulators at the Federal Reserve Board and SEC asleep at the switch, incompetent credit agencies eager to sign off on securitized offerings to collect rating fees — these were some of the main villains of the financial crisis. One must start, though, with the people who borrowed far beyond their means to buy houses. The subprime market, if properly regulated and reasonably transacted, serves a useful purpose in extending credit to responsible lower income groups. However, human proclivity for acting on greedy impulses must be contained to avoid another damaging crisis. Executives, bankers and traders on Wall Street, with the assistance of their friends in the highest levels of government, were allowed to dump billions of dollars of losses on U.S. taxpayers and keep their millions of dollars in bonuses. There are lessons from the past abuse of the subprime market, but one should not be surprised if it happens again.