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Subprime Lender

Subprime Lender

What Is a Subprime Lender?

A subprime lender is a credit provider that has practical experience in borrowers with low or "subprime" credit ratings. Since these borrowers imply a higher liability of default, subprime loans are associated with generally high rates of interest.

Subprime lending turned into a subject of extensive interest in the wake of the 2007-2008 financial crisis, where it was widely seen as adding to the sharp decline in the U.S. housing market.

Grasping Subprime Lending

Subprime lenders are creditors who offer loans to people who don't meet all requirements for loans by traditional lenders. By definition, these subprime borrowers have below-average credit ratings and are in this manner dared to be at greater risk of defaulting on their loans. To alleviate against this risk, subprime lenders use risk-based pricing systems to compute the terms and interest rates of their subprime loans. Due to the additional risk of subprime borrowers, subprime loans constantly carry moderately high interest rates.

Traditionally, the relationship between a subprime lender and a subprime borrower would be somewhat direct. The lender would acknowledge the risk that the borrower could default on their loan, in exchange for an interest rate paid by the borrower. The lender would profit if, on average, the interest earned on the subprime loans were adequately in excess of the principal lost to default. Oftentimes, subprime lenders would guarantee that they have a large and diversified portfolio of subprime loans to deal with their default risk.

In later times, notwithstanding, this relationship among lenders and borrowers has become essentially more complex. This is due to the phenomenon of securitization, by which lenders sell their loans to outsiders who then package those loans into distinct securities. These securities are then sold to investors who might be completely unrelated to the initial lender or the party responsible for bundling the loans.

On account of securitization, it is feasible for subprime lenders to successfully freed themselves of the default risk associated with their subprime loans. By selling those loans to investors through the course of securitization, a subprime lender can now zero in exclusively on starting new subprime loans and afterward selling them off rapidly to a securitization provider. As such, the risk of default is moved from the subprime lender through to the investors who will ultimately possess the subprime loan via the securitized product.

Real World Example of Subprime Lending

This combination of subprime lending and securitization is generally seen as having contributed altogether to the 2007-2008 financial crisis. Long before the crisis, subprime mortgage lenders sold large amounts of subprime mortgages to securitization partners who utilized them to create securitized products known as mortgage-backed securities (MBS). These securities were then sold to different investors all through the world.

One analysis of this practice is that it eliminated the incentive for the subprime mortgage lenders to guarantee that the default risk of their loans stayed inside a reasonable level; on the grounds that the risk of default was moved to the MBS holders, the subprime lenders were incentivized to deliver however many subprime loans as would be prudent, regardless of their default risk. This prompted a consistent decay of mortgage standards, until the average quality of mortgage loans declined to a dangerous and impractical level.

Highlights

  • Since these borrowers carry moderately high default risks, subprime loans carry better than expected interest rates.
  • Subprime lending is the practice of lending to borrowers with low credit ratings.
  • Subprime lending is seen as having contributed to the 2007-2008 financial crisis, due in part to the phenomenon of securitization.