Till a few weeks back, "subprime" was an almost unheard word on the Wall Street. Today the word is all over the place.
So what is "Subprime lending" all about?
A subprime lender is a lender who lends to borrowers, who would generally not qualify for loans from mainstream lenders. The factors that determine interest rates for subprime borrowers are same as that of prime borrowers. Lower the down payment and lower the credit score, higher are the interest rates. The interest rates charged by subprime lenders are generally higher, to cover the risk associated with defaults by subprime borrowers.
For a long time, subprime lending had been a boon for people who got rejected by prime lenders for various reasons – some justified and some unjustified.
However, last few weeks have seen the subprime sector making news for all the wrong reasons.
US’s subprime market constitutes 13.5% of home mortgages and its value makes nearly 20% of the $3 trillion mortgage market.
In recent years subprime lenders threw caution to the wind and started giving loans to one and all – creating a spiral of rising prices in the real estate market.
The lenders took a bigger risk and now will pay a bigger price for it. The downturn in the housing market is leading to more and more loan defaults. This in turn is scaring away funds from subprime companies.
Since December, nearly two dozen major subprime lenders (like Mortgage Lenders Network USA Inc.) have gone bankrupt or issued serious warnings.
This week has seen another major player in trouble. California-based, New Century Financial Corp. has seen its stock battered mercilessly amid speculation that it is filing for bankruptcy soon. New Century is the largest independent U.S. subprime lender. Currently it has stopped accepting new loan applications because some of its financiers are reluctant to infuse fresh funds in the company. The company’s stock has lost 85% of its value in 2007.
Strange it may seem, but the subprime meltdown is also going to create trouble for one of US’s largest car manufacturer - General Motors. For many years General Motors’ finance arm General Motors Acceptance Corporation (GMAC) was a bigger source of income for GM than car sales. GM recently sold off GMAC, but it is still liable for certain loans of GMAC. GMAC has more than $21 billions of subprime mortgages and many of these are likely to go bad. If things worsen from here, GM’s liabilities may threaten its very existence.
Even the bigger names in finance have not been spared. Citigroup, HSBC and Countrywide Financial have issued warnings regarding credit troubles in their subprime arms and have upped their estimate of losses / bad loans. Earnings of Bear Stearns, Lehman Brothers, Goldman Sachs, Merrill Lynch and Morgan Stanley will also be impacted.
It will be sometime before the total impact of the subprime mess will be known. However one thing is clear – the US housing market is unlikely to recover fully from the subprime bubble for many years.
The sad part is that the people who will suffer the most will not be the greedy subprime lenders or the careless mortgage brokers who made fortunes from sales of bad mortgages, but the middle and low income homebuyers who paid inflated prices for homes that they could not afford. Millions may lose their homes because they had bought their homes at an unjustifiably high price.
