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Wednesday, 6 February 2008

What is "subprime"?

In recent weeks we hear very often about "subprime"...subprime mortgage, subprime loan, subprime crisis etc. What exactly is subprime?

“Subprime” voted 2007 word of the year

In its 18th annual words of the year vote, the American Dialect Society voted “subprime” as the word of the year. Subprime is an adjective used to describe a risky or less than ideal loan, mortgage, or investment. Subprime was also winner of a brand-new 2007 category for real estate words, a category which reflects the preoccupation of the press and public for the past year with a deepening mortgage crisis.

Presiding at the Jan. 4 voting session were ADS Executive Secretary Allan Metcalf of McMurray College and Professor Wayne Glowka, Dean of Arts and Humanities of Reinhardt College, chair of the New Words Committee of the American Dialect Society. Wayne edits the column “Among the New Words” in the society’s quarterly journal American Speech.
“When you have investment companies losing billions of dollars over something like bundled subprime loans, then you have to consider whether it’s important,” Professor Glowka said. “You probably also want to think about paying off that third mortgage.”
Word of the Year is interpreted in its broader sense as “vocabulary item”—not just words but phrases. The words or phrases do not have to be brand-new, but they have to be newly prominent or notable in the past year, in the manner of Time magazine’s Person of the Year.
The vote is the longest-running such vote anywhere, the only one not tied to commercial interests, and the word-of-the-year event up to which all others lead. It is fully informed by the members’ expertise in the study of words, but it is far from a solemn occasion. Members in the 118-year-old organization include linguists, lexicographers, etymologists, grammarians, historians, researchers, writers, authors, editors, professors, university students, and independent scholars. In conducting the vote, they act in fun and do not pretend to be officially inducting words into the English language. Instead they are highlighting that language change is normal, ongoing, and entertaining.

Subprime Loan

A type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans. Quite often, subprime borrowers are often turned away from traditional lenders because of their low credit ratings or other factors that suggest that they have a reasonable chance of defaulting on the debt repayment.

Subprime loans tend to have a higher interest rate than the prime rate offered on traditional loans. The additional percentage points of interest often translate to tens of thousands of dollars worth of additional interest payments over the life of a longer term loan. However, getting a subprime loan could still be a good idea if the loan is meant to pay off a higher interest debt (such as credit card debt) and the borrower has no other means for payment. The specific amount of interest charged on a subprime loan is not set in stone. Different lenders may not value a borrower's risk in the same manner. This means that a subprime loan borrower has an opportunity to save some additional money by shopping around.

Subprime Mortgage

A type of mortgage that is normally made out to borrowers with lower credit ratings. As a result of the borrower's lowered credit rating, a conventional mortgage is not offered because the lender views the borrower as having a larger-than-average risk of defaulting on the loan. Lending institutions often charge interest on subprime mortgages at a rate that is higher than a conventional mortgage in order to compensate themselves for carrying more risk.

Borrowers with credit ratings below 600 often will be stuck with subprime mortgages and the higher interest rates that go with those mortgages. Making late bill payments or declaring personal bankruptcy could very well land borrowers in a situation where they can only qualify for a subprime mortgage. Therefore, it is often useful for people with low credit scores to wait for a period of time and build up their scores before applying for mortgages to ensure they are eligible for a conventional mortgage.

Subprime Mortgage Financial Crisis

The subprime mortgage financial crisis of 2007 was a sharp rise in home foreclosures which started in the United States during the fall of 2006 and became a global financial crisis within a year.

The crisis began with the bursting of the housing bubble in the U.S.[2][3] and high default rates on "subprime", adjustable rate, "Alt-A", and other mortgage loans made to higher-risk borrowers with lower income or lesser credit history than "prime" borrowers. The share of subprime mortgages to total originations increased from 9% in 1996, to 20% in 2006.[4] Further, loan incentives including "interest only" repayment terms and low initial teaser rates (which later reset to higher, floating rates) encouraged borrowers to assume mortgages believing they would be able to refinance at more favorable terms later. While U.S. housing prices continued to increase during the 1996-2006 period, refinancing was available. However, once housing prices started to drop moderately in 2006-2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically. By October 2007, 16% of subprime loans with adjustable rate mortgages (ARM) were 90 days delinquent or in foreclosure proceedings, roughly triple the rate of 2005.[5] By January of 2008, this number increased to 21%.[6] During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% versus 2006.[7] As of December 22, 2007, a leading business periodical estimated subprime defaults would reach a level between U.S. $200-300 billion.[8]
The mortgage lenders that retained credit risk (the risk of payment default) were the first to be affected, as borrowers became unable or unwilling to make payments. Major banks and other financial institutions have reported losses of approximately U.S. $130 billion as of January 25, 2008, as cited below. Due to a form of financial engineering called securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third-party investors via mortgage-backed securities (MBS). Individual and institutional investors holding MBS faced significant losses, as the value of the underlying mortgage assets and payment streams declined and became difficult to predict.
In addition, certain legal entities designed to isolate this risk from the originating lenders, called collateralized debt obligations (CDO) and structured investment vehicles (SIV), held substantial amounts of MBS. As the value of payments into these entities declined, their value also declined, forcing the sale of MBS at fire-sale prices in some instances.
The widespread dispersion of credit risk and the unclear impact on large banks, MBS, CDO, and SIV caused banks to reduce their loans to each other or make them at higher interest rates. Similarly, the ability of corporations to obtain funds through the issuance of commercial paper was impacted. This aspect of the crisis is consistent with a credit crunch. The liquidity concerns drove central banks around the world to take action to provide funds to member banks to encourage the lending of funds to worthy borrowers and to re-invigorate the commercial paper markets.
The combination of impacts due to credit risk and liquidity risk caused several major corporations and hedge funds to shut down or file for bankruptcy. Stock market declines among both depository and non-depository financial corporations were dramatic. Many hedge funds and other institutional investors holding MBS also incurred significant losses.
With interest rates on a large number of subprime mortgages due to adjust upward during the 2008 period, U.S. legislators and the U.S. Treasury Department are taking action. A systematic program to limit or defer interest rate adjustments was implemented to limit the impact. In addition, lenders and borrowers facing defaults have been encouraged to cooperate to enable borrowers to stay in their homes. Restrictions on lending practices are under consideration. Many lenders have stopped subprime lending or dramatically curtailed it.
The subprime crisis places downward pressure on economic growth, because significant losses from subprime loans have reduced the willingness of banks to loan funds to other financial institutions and to consumers. Such loans increase investment by businesses and consumer spending, which drive the economy. A separate but related dynamic is the downturn in the housing market, where a surplus inventory of homes has resulted in a significant decline in new home construction and housing prices in many areas. This also places downward pressure on growth.[9] The risks to the broader economy created by the financial market crisis and housing market downturn were primary factors in the January 22, 2008 decision by the U.S. Federal reserve to cut interest rates and the economic stimulus package currently under consideration by the U.S. Congress.[10][11] Both actions are designed to stimulate economic growth and inspire confidence in the financial markets.
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