In the fall of 2008, financial institutions previously thought to be “too big to fail” teetered precariously on the edge of bankruptcy. In England, banks quailed as customers rushed to withdraw money from the failed Northern Rock and Lehman Brothers, a stalwart of the investment banking system closed down. The financial world only found some form of stability when global governments stepped in to guarantee the banks. The crisis was precipitated by the trading of a financial instrument called a subprime mortgage.
A subprime mortgage is a type of mortgage that is offered to borrowers with a higher than average risk of default. To offset this high risk of defaulting on the loan, lenders impose a higher interest on subprime loans. A subprime loan is often defined as the riskiest loan in the market due to the high chances of the borrower not being able to repay the loan.
Subprime mortgages are offered to borrowers who, under normal circumstances would not qualify to receive a loan and would not have access to the credit market. This includes those with low credit ratings. Credit ratings are affected by a plethora of different factors, such as lack of capital holdings, history of late payments, or excessive debt. Although there is no standard definition, in the finance industry, subprime mortgages are characterised as those offered to applicants with a FICO credit rating of below 640.
These types of mortgages are usually guaranteed against the underlying asset. For example, a subprime mortgage issues to purchase real estate would use the property as a guarantee. In the case of default, the lender would then be able to repossess the property in lieu of the debt.
The problem with subprime mortgages became evident as the property bubble flattened, and then burst. As borrower after borrower was unable to repay, banks had to repossess homes and property – but as these homes and property had lost their value in the real estate market, banks found themselves with bad debts and no hope of regaining the value of the subprime mortgages they had issues.
Although the financial crisis is often blamed on the lenders of subprime mortgages, there is a legitimate market for these types of mortgages, as long as it is properly regulated and controlled. Subprime mortgages by themselves are not an unnecessary evil, but lenders should be made to follow the correct procedures for issuing them.