Understanding Subprime Loans: Causes & Impact

Subprime loans are credit products issued to borrowers with relatively lower credit scores or lacking in credit history. These loans were at the center of the economic recession that peaked during 2009, as lending standards were eased as a result of a government-sponsored push to increase domestic home ownership, which resulted in aggressive lending to unqualified borrowers. The problem was perpetuated by rolling up the bad loans into collateralized mortgage obligations. CMOs turned out to be an ideal vehicle for deferring the problem. The economic crisis has subsided, and banks have re-entered the subprime lending market.

The Subprime Market

Banks issue subprime loans for a number of reasons. Commercial banks' share of the subprime lending market has increased, as the recession-driven collapse of the subprime market resulted in a shake-out of non-bank mortgage originators that previously played a much larger role in subprime mortgage origination. According to the mortgage industry trade publication Inside Mortgage Finance, whereas mortgage brokers dominated the subprime market prior to the 2009 recession, their market share has fallen to 9.7 percent. Also, partly due to the economic recession, demand for subprime auto loans have increased, and banks have entered this market as well.

High Interest Rates

Subprime lenders assume greater default risk by lending to buyers with no, or poor credit histories, and are compensated in the form of higher interest rates. Interest rates on subprime mortgage loans can be several percentage points higher than for prime loans with comparable terms. The same is true for subprime auto and personal installment loans, although mortgage loans are by far the largest segment. These kinds of returns are impossible for commercial banks to disregard.

Community Reinvestment Act

Another reason commercial banks make subprime loans is that it fits their mandate to contribute to the economic growth of their community. In 1977, Congress passed the Community Reinvestment Act in an effort to reduce discriminatory lending practices, and to increase home ownership among minorities. The passing of this legislation led to huge increase in subprime lending, still evident today.

Loan Collateralization

Growth in the market for collateralized debt obligations, which allow banks to bundle the loans held on their balance sheet, and sell them to investors, have greatly increased commercial bank's subprime lending activities. The strength of the CDO market has allowed banks to reduce the balance sheet risks associated with subprime loans that were potentially of lower quality than at the time of origination, by simply selling them off. This also provided liquidity to banks, which is critical to maintaining capital adequacy. This includes primarily subprime mortgage and auto loans, but also subprime installment loans to a lesser degree.

During the economic recession that peaked during 2009, the secondary market for collateralized mortgage obligations shrunk dramatically, but has rebounded. The market for subprime auto loans grew organically while the overall CDO market recovered, and now represents a small portion of the overall market.