What is a Subprime Market?

John Lister

A subprime market is one dealing with loans classed as the most risky in their sector. The risk here is that the borrowers will not repay the loan. In most cases, the interest rates for such borrowers will be higher, meaning both the risks and potential returns for investors in the market are higher. There have been cases where the complexities of the financial markets meant that subprime loans were packaged together with standard loans in financial products. This was blamed for some of the economic problems which began in the United States markets in the latter half of the 2000s.

People with a poor credit history are typically classified in the subprime credit category.
People with a poor credit history are typically classified in the subprime credit category.

There are multiple reasons why an individual loan might be described as subprime. The most common would be that the amount borrowed, and more specifically the proposed repayment schedule, is at a particularly high ratio to the disposable income of the borrower. Another possible cause would be if the borrower has a poor credit history. A subprime market might also cover borrowers who cannot provide proof of a stable income, such as self-employed people who are allowed to "certify" their own claimed income. In this situation, the borrower may in fact easily be able to repay the loan, but the risk exists because of the lack of information and certainty for the lender.

Within the United States, the most common objective classification of a subprime loan is one where the borrower has a FICO score of 620 or lower. FICO is the most widely used credit rating system, and the possible range of scores is 300 to 850.

In its simplest form, the phrase subprime market simply refers to the market for lending to such borrowers. This could be a market in mortgages, credit cards or any other form of lending. The market in this context is simply different lenders competing to get business from different borrowers.

Today, however, somebody using the term subprime market is more likely to be referring to the market for lenders selling the rights to mortgages to investors. For example, a mortgage firm might sell on a batch of mortgages to an investment firm, which would then receive future payments from the homeowners. The investment firm would then sell the rights to these payments to multiple investors who would each take a chunk of the entire package of loans. The idea is that this spreads the risk and allows investors to invest an amount of their choosing.

From 2006 onwards, problems started to develop in this type of subprime market. One problem was that the number of subprime borrowers failing to make repayments rose, most commonly blamed on a combination of them borrowing too much money and on rising interest rates. Another problem was that the repackaging process when loans were sold on to investors had become extremely complicated, meaning that many packages contained a mixture of standard loans and subprime loans. In some cases, the process meant the presence of the subprime loans in the package had not been clearly indicated to investors. The rising number of defaults meant many investment firms found their investments were really worth much less than they realized, which led to serious financial problems.

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