How The Subprime Market Works

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The sub-prime market is part of the private mortgage market, which mainly consists of borrowers with low credit ratings. This market for residential mortgages is active in places such as the United States and some European countries.

Subprime can also point to a security that comes with a return which has a higher prime rate, referred to as C-paper. The borrowers in the subprime domain are synonymous with adverse credit reports due to higher default rates, over indebtedness, missed instalments or payments and registered bankruptcies.

In essence, the subprime market affords undeserving borrowers a chance to access credit, which they would otherwise not qualify for. The subprime risk is acceptable as long as the affected borrowers serve their mortgage contract (sub-prime loans).

But as can be expected, the lenders in this market face much greater risk than in the traditional credit market, and have to implement measures to mitigate the risk.

Of crucial importance to the measurement of credit quality is the debt-to-income ratio, i.e, the ratio between gross income and total debt service, which should not exceed 45% of gross income. The loan-to-value-ratio in turn provides information on the equity commitment, which should be at least 10%.

All factors are then combined into a rating (or credit score), at least 620 points must be achieved on a scale from 350 to 850th. If a credit score of 620 is not attained, the concerned borrower would typically have to resort to the subprime market, as a last option.

Unlike borrowers with a credit score above 720, those falling below 620 are considered by subprime lenders if they have a sufficient income, and thus may qualify for a subprime mortgage loans. Lenders mitigate the risks involved by charging a higher interest rate.

In relation to subprime credit cards, the lender could charge higher late fees, higher over-the-limit fees, yearly fees, or up-front fees for the card. By so doing the lender is in a position to make up for the inflated costs incurred while servicing and collecting on the accounts which come with an unsually higher default rate.

The rise in the granting of this particularly risky credit began many years ago, and the majority of such loans were issued with the intention of selling them into securitization conduits.

These are special purpose entities that are behind the issuing of residential mortgage-backed securities (RMBS), bonds, securities and other investment vehicles meant for resale to pension funds and other investors.



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