Subprime Loans: The Under-the-Radar Loans that Felled a Market

The Under-the-Radar Loans that Felled a Market

In the awakening of the housing growth market subprime loans sky-rocketed.  Prior to the onset of subprime loans; borrowers whose credit scores and those that were considered too risky in the eyes of lenders did not meet the criteria to warrant a loan from many lenders. One of the most notable areas of subprime lending was in the area of home buying. Gilbert noted, The U.S. Department of Housing and Urban Development, in defining subprime lending, says that “typically, subprime loans are for persons with blemished or limited credit histories. The loans carry a higher rate of interest than prime loans to compensate for increased credit risk ”(Gilbert, 2011, p.89).  Borrowers were able to qualify to buy homes without stringent criteria that were previously established.    

“Sub-prime loans are generally made to borrowers with blemished credit scores or very low equity loans. Subprime borrowers pay large premiums to account for their higher probability to default and pre-pay than more credit worthy borrowers in the prime loan sector” (Sarmiento, 2009, p. 181).  In the success of subprime lending the housing market soared, it made buying a home affordable and created a benefit to lenders, as it allowed the lender to share the wealth. “Investors in search of high yielding assets and banks met the demand for the higher credit risk in sub-prime securities originated by banks and brokers, which earned fees by pooling and slicing the risks in these loans” (Sarmiento, 2009, p. 181).  The loan are settled with the buyer, then the lender sells it to another investor and that investor then sells it to another.  This writer interprets this as a lender to buyer to seller rotational model, see Figure 1.

                                                                                                                                                                                                                                                                    

Gilbert, J., (2011). Moral Duties in Business and Their Societal Impacts. The Case of the Subprime Lending Mess. Business & Society Review (0045609), 116(1), 87-107.                           doi 10.1111/j.1467-8594.2011.00378.x Sarmiento, C. (2009). Regime changes in sub-prime margins under the US housing bubble. Applied Financial Economics, 19(3), 175-182. doi:10.1080/09603100701857898