Subprime Lending

What is a Subprime Loan?

The term subprime lending is assigned to loans (mortgage, credit card, auto, etc) that are issued to the riskiest group of borrowers.  Subprime borrowers typically have below average credit scores and are tainted with more serious blemishes in their credit history; such as, bankrucpcy, charge-offs, debt consolidation, late payments, and high amounts of debt in relation to their credit lines.  Generally, a subprime borrower will carry a FICO score of less than 620 and a higher debt to income ratio and interest rate than a prime borrower.  FICO scores of above 680 typically receive prime rates, while scores between 620 and 680 are considered Alt-A loans.  You may hear the term B-paper or even C and D paper.  These refer to the different credit quality tiers within the subprime classification.  The further down the rung, the deeper the credit issues of the borrower. 

There is a high correlation between subprime loans and foreclosures, predominately with ARM loans which have a forclosure rate of nearly 20%. 

Subprime loans have the highest prepayment speed out of any type of loan due to the "curing effect".  As borrowers improve their credit score over time, they begin to qualify for better loan products which carry better rates; hence, higher rates of refinancing. 

Subprime & Financial Crisis

The default of many of the subprime loans issued after 2001 served as the primer to the subprime mortgage crisis that brought the financial system to a screeching halt.  Freddie Mac and Fannie Mae issued mortgage backed securities which purchased these loans.  Once these loans began to default, so did the price of the MBS securities as well as all the derivatives that were created using these MBS securities. 

Tim Ord
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