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subprime lending

Page history last edited by Brian D Butler 10 years, 11 months ago

 

 

 

 

 

 

Table of Contents:


 

Subprime Lending

 

see more in our Real estate industry discussion, and on the credit crisis of 2007

 

 

Subprime lending, also called B-paper, near-prime, or second chance lending, is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history.  Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, poor credit history, and adverse financial situations usually associated with subprime applicants.  Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others. The term "subprime" refers to the credit status of the borrower (being less than ideal), not the interest rate on the loan itself. 

 

The origin of the trouble started out when banks learned how to turn mortgages into securities, or bonds, that could then be sold on markets.  (see securitization of mortgages)

 

Subprime "crisis"

 

  • lending to un-credit worthy people
  • less credit ratings = higher risk
  • banks would then sell off those loans as bonds, so the banks did not carry (or worry) about the risk
  • mortgage backed bonds
  • Problem occurred when people couldnt pay off loans.  Too many loans to people that couldnt pay back
  • low income / low quality borrower = problems
  • banks were not looking enough at borrowers debt/ income rates
  • But, banks dont end up with the losses- becasue they already sold off loans
  • people suffering = those with holding of mortgage backed securities
  • lots of people bought those mortgage backed securities because interest rates on traditional bonds were low (fed funds rate was low), so investors chose a few extra basis points, for these securities (which they thought were low risk- AAA rated)
  • they put together 1000's of loans + sell as a bond
  • securitization of mortgages
  • this allowed banks to get away with risky lending (which they otherwise would not have been able to do) - it was off their books, so it was "ok"
  • farmed out risk to investors

 

 

 

The controversy surrounding subprime lending has expanded as the result of an ongoing lending and credit crisis both in the subprime industry, and in the greater financial markets which began in the United States. This phenomenon has been described as a financial contagion which has led to a restriction on the availability of credit in world financial markets. Hundreds of thousands of borrowers have been forced to default and several major American subprime lenders have filed for bankruptcy.

 

for more information see wikipedia article

 

Subprime lending is the practice of extending credit to borrowers with credit characteristics - e.g. sub-620 FICO scores - that disqualify them from loans at the prime rate(hence, subprime). As subprime loans are more likely to go into default, lenders can charge a premium rate to compensate for the added risk. Since the mid-1990s, subprime lending in the U.S. has taken off, increasing from $33 billion in 1993 to $332 billion in 2003. Most of this growth has stemmed from the mortgage industry: 20% of all mortgages originated in 2006 were considered to be subprime, a rate unthinkable just ten years ago. This substantial increase is attributable to industry enthusiasm: banks and other lenders discovered that they could make hefty profits from origination fees, bundling mortgages into securities, and selling these securities to investors.

 

 

The rush to enter this space can be seen as the result of an increased perception that the risks posed by subprime borrowers can be mitigated through advanced risk management techniques. This perception has been fostered by a number of trends in the mortgage industry, particularly trends in home price appreciation and the rise of mortgage-backed securities. The stratospheric rise in home prices across the country led many financial institutions to believe that losses could largely be regained through the sale of greatly appreciated homes. While this logic may have held for a brief period, the gradual decline of home prices in 2006 led to the possibility of real losses.

 

The practice of subprime lending has widespread ramifications for many companies, with direct impact being on lenders, financial institutions and home-building concerns. However, it has a broader indirect impact on the economy at large, as evidenced by the credit crunch in 2007.

 

 

 

Looking for opportunities after the bursting of the realestate bubble:

 

Apollo raises $1.4 billion fund

Private-equity group Apollo Management has raised $1.4 billion for its European property fund. Equity from Apollo European Real Estate Fund III will be used to invest in struggling commercial properties throughout the U.K., France, Germany, Switzerland, Italy, Spain and Eastern Europe. Reuters (03/07)

 

 

 

Impact on Venture Capital industry

 

venture capital trends

 

 

 

 

Subprime crisis in the US, and what its effect is on China

 

    see more:  Changes are happening in China

 

Interestingly, the subprime lending crisis in the US, and the ensuing credit crisis has given the Chinese another excuse to avoid opening up their financial market to Western banks.  This is a shame for two reasons, (1) it would benefit the chinese consumers, and (2) Western governments want to open up China to capitalism and their banks in exchange for opening up their markets to Chinese products

 

Subprime crisis may ‘pause’ China reforms

April 2 2008:  Hank Paulson, the US Treasury secretary, acknowledged on Wednesday that the fall-out from the subprime crisis in the US had “no doubt” given the Chinese “pause” about the benefits of financial liberalisation.  read more from  FT.com

 

 

 

Housing index:

 

There are three indexes out there.  Only one is good.  See S&P Case-Shiller index

 

Be very careful of the REALATORS index....which is too optimistic, and also of the FEDERAL Reserve index, which is based on the data from Fannie May, Freddie Mac....because they dont include subprime lending, and are therefore too optimistic as well.  

 

The only good, best index is from Case/ shiller.

 

 

 

 

 

Links

 

 

 

 

see also:  subprime lending, Double bubble trouble - two bubbles burst in the USA, structured finance, financial innovations, securitization of mortgages , credit crisis of 2007

 

 

 

 

 

 

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