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|[[Image:subprimeshare.png|thumb|350px|right|Subprime mortgages have increased over time as a fraction of all mortgages written. ''Source: Edward Gramlich, FRB, and Mara Lee, NPR'']]||[[Image:subprimeshare.png|thumb|350px|right|Subprime mortgages have increased over time as a fraction of all mortgages written. ''Source: Edward Gramlich, FRB, and Mara Lee, NPR'']]|
|The subprime mortgage market lends money to people who don’t meet the credit or documentation standards for ordinary mortgages. Since subprime borrowers often have credit problems or low incomes, there’s a greater chance that they won’t pay back their debts, making subprime mortgages inherently risky for lenders. To compensate for this added risk, banks and other lenders charge higher [[interest rates]] on subprime mortgages. Over the past ten years, these rates have been about 2% higher than prime rates, making subprime lending potentially very lucrative.||The subprime mortgage market lends money to people who don’t meet the credit or documentation standards for ordinary mortgages. Since subprime borrowers often have credit problems or low incomes, there’s a greater chance that they won’t pay back their debts, making subprime mortgages inherently risky for lenders. To compensate for this added risk, banks and other lenders charge higher [[interest rates]] on subprime mortgages. Over the past ten years, these rates have been about 2% higher than prime rates, making subprime lending potentially very lucrative.|
|The subprime industry has always existed, but didn't take off until the mid-1990s. Historically, lenders considered the risk to be too large to issue significant amounts of subprime debt. A number of factors changed this opinion, however, driving banks to originate subprime mortgages in larger and larger numbers.||The subprime industry has always existed, but didn't take off until the mid-1990s. Historically, lenders considered the risk to be too large to issue significant amounts of subprime debt. A number of factors changed this opinion, however, driving banks to originate subprime mortgages in larger and larger numbers.|
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|This article describes a concept which could impact a variety of companies, countries or industries. To see what companies and articles reference this concept page, click here.|
For information on the 2007 subprime crisis and credit crunch, click here.
Subprime lending is the practice of extending credit to borrowers with certain credit characteristics -- e.g. a FICO score of less than 620 -- that disqualify them from loans at the prime rate (hence the term 'subprime'). Subprime lending covers different types of credit, including mortgages, auto loans, and credit cards. Since subprime borrowers often have poor or limited credit histories, they are typically perceived as riskier than prime borrowers. To compensate for this increased risk, lenders charge subprime borrowers a premium. For mortgages and other fixed-term loans, this is usually a higher interest rate; for credit cards, higher over-the-limit or late fees are also common. Despite the higher costs associated with subprime lending, it does give access to credit to people who might otherwise be denied. For this reason, subprime lending is a common first step toward “credit repair”; by maintaining a good payment record on their subprime loans, borrowers can establish their creditworthiness and eventually refinance their loans at lower, prime rates.
Subprime lending became popular in the U.S. in the mid-1990s, with outstanding debt increasing from $33 billion in 1993 to $332 billion in 2003. As of December 2007, there was an estimated $1.3 trillion in subprime mortgages outstanding. 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.
These banks and lenders believed that the risks of subprime loans could be managed, a belief that was fed by constantly rising home prices and the perceived stability of mortgage-backed securities. However, 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. As home values declined, many borrowers realized that the value of their home was exceeded by the amount they owed on their mortgage. These borrowers began to default on their loans, which drove home prices down further and ruined the value of mortgage-backed securities (forcing companies to take write downs and write-offs because the underlying assets behind the securities were now worth less). This downward cycle created a mortgage market meltdown.
The practice of subprime lending has widespread ramifications for many companies, with direct impact being on lenders, financial institutions and home-building concerns. In the U.S. Housing Market, property values have plummeted as the market is flooded with homes but bereft of buyers. The crisis has also had a major impact on the economy at large, as lenders are hoarding cash or investing in stable assets like Treasury securities rather than lending money for business growth and consumer spending; this has led to an overall credit crunch in 2007. The subprime crisis has also affected the commercial real estate market, but not as significantly as the residential market as properties used for business purposes have retained their long-term value.
The subprime mortgage market lends money to people who don’t meet the credit or documentation standards for ordinary mortgages. Since subprime borrowers often have credit problems or low incomes, there’s a greater chance that they won’t pay back their debts, making subprime mortgages inherently risky for lenders. To compensate for this added risk, banks and other lenders charge higher interest rates on subprime mortgages. Over the past ten years, these rates have been about 2% higher than prime rates, making subprime lending potentially very lucrative. The subprime industry has always existed, but didn't take off until the mid-1990s. Historically, lenders considered the risk to be too large to issue significant amounts of subprime debt. A number of factors changed this opinion, however, driving banks to originate subprime mortgages in larger and larger numbers.
Home price appreciation
Home price appreciation seemed an unstoppable trend from the mid-1990's through to today. This "assumption" that real estate would maintain its value in almost all circumstances provided a comfort level to lenders that offset the risk associated with lending in the subprime market. Home prices appeared to be growing at annualized rates of 5-10% from the mid-90s forward. In the event of default, a very large percentage of losses could be recouped through foreclosure as the actual value of the underlying asset (the home) would have since appreciated.
Lax lending standards
The reduced rigor in lending standards can be seen as the product of many of the preceding themes. The increased acceptance of securitized products meant that lending institutions were less likely to actually hold on to the risk, thus reducing their incentive to maintain lending standards. Moreover, increasing appetite from investors not only fueled a boom in the lending industry, which had historically been capital constrained and thus unable to meet demand, but also led to increased investor demand for higher-yielding securities, which could only be created through the additional issuance of subprime loans. All of this was further enabled by the long-term home price appreciation trends and altered rating agency treatment, which seemed to indicate risk profiles were much lower than they actually were.
As standards fell, lenders began to relax their requirements on key loan metrics. Loan-to-value ratios, an indicator of the amount of collateral backing loans, increased markedly, with many lenders even offering loans for 100% of the collateral value. More dangerously, some banks began lending to customers with little effort made to investigate their credit history or even income. Additionally, many of the largest subprime lenders in the recent boom were chartered by state, rather than federal, governments. States often have weaker regulations regarding lending practices and fewer resources with which to police lenders. This allowed banks relatively free rein to issue subprime mortgages to questionable borrowers.
Adjustable-rate mortgages and interest rates
Adjustable-rate mortgages (ARMs) became extremely popular in the U.S. mortgage market, particularly the subprime sector, toward the end of the 1990s and through the mid-2000s. Instead of having a fixed interest rate, ARMs feature a variable rate that is linked to current prevailing interest rates. In the recent subprime boom, lenders began heavily promoting ARMs as alternatives to traditional fixed-rate mortgages. Additionally, many lenders offered low introductory, or “teaser”, rates aimed at attracting new borrowers. These teaser rates attracted droves of subprime borrowers, who took out mortgages in record numbers.
While ARMs can be beneficial for borrowers if prevailing interest rates fall after the loan origination, rising interest rates can substantially increase both loan rates and monthly payments. In the subprime bust, this is precisely what happened. The target federal funds rate (FFR) bottomed out at 1.0% in 2003, but it began hiking steadily upward in 2004. As of mid-2007, the FFR stood at 5.25%, where it had remained for over one year. This 4.25% increase in interest rates over a three-year period left borrowers with steadily rising payments, which many found to be unaffordable. The expiration of teaser rates didn’t help either; as these artificially low rates are replaced by rates linked to prevailing interest rates, subprime borrowers are seeing their monthly payments jump by as much as 50%, further driving the increasing number of delinquencies and defaults. Between September of 2007 and January 2009, however, the U.S. Federal Reserve slashed rates from 5.25% to 0-.25% in hopes of curbing losses. Though many subprime mortgages continue to reset from fixed to floating, rates have fallen so much that in many circumstances the fully indexed reset rate is below the pre-existing fixed rate; thus, a boon for some subprime borrowers.
A major issue is regarding the 'work outs', i.e. when the lender compromises with the borrower to avoid default and repossession. Mortgage originators packaged loans through the process of securitization, which effectively moves the loan off the bank's books to that of the investor. However, the majority of mortgage companies retained the rights to service the mortgages for a fee. Ultimately the servicers are akin to a trustee for these mortgage pools. It is the servicer who generally handles foreclosure and workout proceedings acting as an agent for the holders of the underlying mortgages. It is of this servicer/security-holder arrangement whereby the servicer has a fiduciary duty to the holder, which is in place via contract, that there are endless issues with modifying loans.
Mortgage-backed securities and Collateralized debt obligations
As a result of investment bank innovations, such as collateralized debt obligations (CDOs), the default risk of U.S. home mortgages have been spread across markets all over the world. In order to spread their risk, mortgage banks began issuing mortgage-backed securities (MBS) - bonds whose repayments are tied to a large pool of mortgages. By issuing these securities, lenders were able to free up additional capital on their balance sheets, thus allowing them to make more loans and increase the overall velocity of their lending business. This practice was further driven by significant growth in investor appetite as it effectively provided automatic loan diversification, spreading the damage done by a single default across a pool of thousands of loans.
Subsequently, MBSs were increasingly used as components in structured products sold by Wall Street, most commonly CDOs. The key innovation of these structured products was that rather than spread the risk from these mortgage pools evenly across all bondholders, it would instead distribute losses hierarchically to investors, with status being dependent on expected yield. Because of these structures, the conventional wisdom ran that investment grade loans could be created out of low quality credit pools.
CDOs backed by MBSs were given further credence when they contracted with monoline bond insurers to guarantee the assets. In turn, national credit rating agencies gave CDOs the same score as their insurer, conferring the same rating on mortgage-backed securities that a secure municipal bond earned, since the same insurance companies guaranteed both types of assets. Mortgage-backed securities which began to see spectacular profits due to the boom in structured product issuances and the large group of investors who were attracted to their high ratings. Recent developments have suggested that the rating agencies may have applied a different scale to tranches of structured products, thus leading investors to believe that the probability of default on their investments was substantially lower than the reality.
Falling values of the CDOs backed by risky mortgage backed securities have resulted in write-downs and losses for many Wall Street investment banks. On November 8, 2007 Citigroup Inc's global markets unit announced that total write-downs of collateralized debt obligations by Wall Street Investment Banks will probably climb to $64 billion.
Structured Investment Vehicles (SIVs)
Structured investment vehicles (SIVs) are off-balance sheet entities that invest in highly rated debt securities and finance themselves by issuing senior debt and capital. The goal of a SIV is to earn a net spread between the yield on its asset portfolio and its funding costs. Senior debt normally takes the form of commercial paper and medium-term notes. SIVs invest predominantly in investment-grade debt securities (usually with a weighted average rating in the AA/Aa range) in accordance with individual asset and portfolio limits agreed with the rating agencies. Because of the nature of its financing, an SIV is highly dependent on maintaining the highest possible short-term and long-term credit ratings. SIVs differ from cash CDOs of asset-backed securities in that their portfolios are marked-to-market and their ratings are based on capital models that are in accordance with the requirements of credit rating agencies.   On November 7, 2007 Moodys' Investors Service said that it placed $33 billion of structured investment vehicles on a watch list for possible downgrades on their ratings. Some SIVs are in trouble because they invested heavily in subprime mortgages. SIV senior note ratings are vulnerable to declines in portfolio values and being unable to refinance maturing debt. Three of the seven SIVs that could be downgraded are managed by Citigroup. The Citigroup SIVs have no direct exposure to U.S. subprime assets, but have about $70 million of indirect exposure to subprime assets through AAA-rated collateralized debt obligations that hold mortgage debt. 
Falling home prices and rising interest rates have led to higher defaults and resulted in the collapse of the subprime mortgage market. Subprime lenders were among the worst impacted, as investor appetite quickly evaporated, leaving them unable to offload their portfolio of rapidly devaluating loans. This resulted in numerous lender bankruptcies, such as New Century. In addition, the subsequent devaluation of subprime-backed securities such as Collateralized debt obligation (CDO) has led to volatility in financial markets around the world. Although subprime mortgages only made up a small percentage of all mortgages, the default of subprime mortgages caused a chain reaction. The defaults led to a drop in overall house prices which caused homeowners to be economically better off to default on their expensive mortgage which was assessed during the boom and simply buy a cheaper mortgage. This resulted in holders of subprime-backed securities, ranging from small firms all the way to Wall Street’s largest investment banks, have also lost vast sums of money as a result of the subprime bust.
The impact on financial markets was made worse when several agencies like Moody's (MCO), Standard & Poor's, and Fitch slashed their ratings on billions of dollars worth of subprime-related bonds and CDOs. There has been some controversy surrounding the assessment of CDOs by credit rating agencies such as Moody’s and Standard & Poor’s. They have been accused of ignoring key credit risks and compromising their rating standards by providing investment grade ratings to CDO tranches without sufficiently testing their modeling methodology.
In addition to the damage done to subprime lenders and holders of securities backed by subprime mortgages, the bust has impacted the entire U.S. housing market. In 2006, around 1.3 million mortgages were in default, up 42% from 2005. The increased number of defaults has led to a glut of repossessed homes on the market, which is lowering residential real estate prices across the board. This harms both the lenders attempting to sell the houses and people who still hold subprime mortgages. As real estate prices fall, some borrowers are finding themselves with houses that aren't worth as much as the loans they own on them. As of December 31, 2007, average loan-to-value ratios for several of the nation's top lenders were 80% or higher. This situation, called negative equity, can actually make it cheaper for borrowers to default than it would be for them to repay their mortgages. This can harm lenders, as the original collateral for some mortgages (the house) is now essentially gone. If they repossess and sell a house with negative equity, they'll actually lose money. Fannie Mae (FNM) announced an agreement on January 29th, 2009, to help reduce mortgage foreclosures from their portfolio of loans. They plan to work with the Neighborhood Assistance Corporation of America to renegotiate some of their loan terms to decrease interest payments and principal levels in order to help troubled buyers meet their loan obligations.
Investment banks - many large investment firms have seen their stock prices plummet as a result of the subprime bust.
Construction and home improvements
There are very few "winners" in the current subprime bust. The closest thing to winners are companies who have limited exposure to subprime, adjustable-rate mortgages, and securities backed by these mortgages. Even so, limited exposure just means that they're not losing as much money as others; it says nothing about actually making money.
When it's easy to buy homes, rental prices drop. When financing for mortgages dries up, people rent instead of buying. As a result, Apartment REITs, which own and operate rental apartments, benefit in some areas from the subprime fallout as the decreased availability of mortgages makes rental apartments more attractive.
Other potential winners are the few hedge funds that have bet against the subprime market recently, by shorting subprime-heavy firms' stocks and securities backed by subprime mortgages.
Commercial Real Estate Investment Trusts (REITs)
Commercial REITs have faired well relative to REITs with significant holdings in residential property, as the subprime lending crisis has primarily affected home mortgages.
On December 6, 2007, President Bush and Treasury Secretary Henry Paulson announced a foreclosure relief plan for approximately 1.2 million Americans who have felt the greatest impact from the subprime crisis. The plan is specifically targeted towards those who will be unable to make mortgage payments at higher interest rates. The plan includes a five year freeze on interest rates for certain borrowers with adjustable rate mortgages resetting early in 2008. It excludes individuals who are more than 30 days late at the time the plan is implemented or have been more than 60 days late at any time within the previous 12 months. According to Barclays Capital, the play will only cover approximately 240,000 of the 2 million subprime ARMs that are expected to reset over the next two years.
In late July 2008, Presiden Bush signed a bill into law that provided a bailout to subprime mortgages. This bill was originally known as the Dodd-Frank Bill after its sponsors. The law gives the Federal Housing Administration the authority to insure up to $300 billion in refinanced mortgages. It also gives the US Treasury Department the power to protect subprime issuers like Fannie Mae and Freddie Mac. This bill was passed to slow down subprime foreclosures and the worsening housing market as a whole.