Subprime Lending

Not that many years ago, subprime loans almost brought down the global economy. The financial world collectively vowed to never again go overboard advancing money to people considered unlikely to pay it back. But in the U.S., some forms of subprime are on the rise again, primarily in auto loans and also in small-business lending.

Not that many years ago, subprime loans almost brought down the global economy. The financial world collectively vowed to never again go overboard advancing money to people considered unlikely to pay it back. But in the U.S., some forms of subprime are on the rise again, primarily in auto loans and also in small-business lending. That has some observers worried — and others calling for more such lending. Not all subprime loans are bad, they say, and it’s not just banks saying it. Consumer advocates want more people to have access to loans while economists see tight credit playing a big role in holding back economic recovery. Maybe subprime mortgages are the medicine the economy needs. Or maybe subprime is such a slippery slope that we’re better off not going there. Is it possible to do just the right amount of risky lending?

The Situation

The subprime rebound has been fastest in auto loans, although it’s still below its pre-crisis peak. In addition to handing out loans to more borrowers with low credit scores, U.S. auto lenders have eased terms by giving consumers as long as seven years to repay — increasing the total they pay in the process. The number of late payments and car loans in default has risen. Reports of aggressive collection methods, onerous terms and hasty underwriting has led the U.S. Justice Department to subpoena to auto lenders seeking information on matters such as the criteria they use for deciding who to lend to. Other lenders have expanded the equivalent of subprime lending to small businesses, charging annual interest rates of 100 percent or more. The picture is different, however, in home loans. Lenders originated just $1 billion in subprime mortgages in 2014′s second quarter — a pittance compared with the $168 billion in subprime mortgages handed out in the third quarter of 2005 at the housing bubble’s peak. As a result, many first-time homebuyers have been locked out of the market and housing prices have stagnated. Even so, the return of bonds backed by bundles of riskier mortgages — now known as nonprime – has some regulators worried.


Source: Federal Reserve Bank of New York Source: Federal Reserve Bank of New York

The Background

Almost since the dawn of civilization there have been tensions between lenders and borrowers. As early as 350 B.C., Aristotle said the petty usurer was “hated with most reason.” Shakespeare’s “Merchant of Venice” made the name of its antagonist, Shylock, into a byword for usury. The word subprime didn’t enter the popular lexicon until the 1990s. At the time, the term referred to credit scores below levels that qualified for prime, or conventional, loans. Definitions varied: the cutoff was sometimes set at 620 and sometimes at 650, roughly equal to the bottom 10 percent. Then, as the U.S. housing market heated up a decade ago, subprime took off. More subprime loans were securitized, that is, bundled together and sold to investors as the equivalents of bonds. Brokers and banks made fat fees for making loans, and investors collected higher-than-prime interest rates. That combination led lenders to make ever more loans to ever more stretched borrowers, with some of the riskiest and most costly loans peddled to blacks and Hispanics. A surge in defaults sparked the worst recession since the Great Depression. There have been more than 7 million foreclosure since the start of 2007; according to RealtyTrac, roughly 700,000 of those homes were purchased entirely with borrowed money.

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