business corporate responsibility economics

what is sub-prime lending?

Since the wheels came off the economy we’ve regularly heard Gordon Brown blame the American sub-prime lending business for getting us into this mess. It was back in the news yesterday as HSBC confessed that they had lost $15 billion in “catastrophic investment” in the subprime market? But what is the sub-prime market?

I’ve just finished reading ‘Maxed Out’ by James Scurlock, and I’ve found out a bit more about it. The sub-prime market is essentially lending services for those who really shouldn’t be borrowing. It provides loans, credit cards, mortgages and refinancing opportunities for those who are already in default, have been bankrupt before, or have a poor credit rating.

We used to have other names for people who loan money to those who can’t afford it – sharks, predatory lenders, bandits – all of those would be appropriate terms in my opinion.

Here’s how it works, according to Scurlock:

“The client, usually a minority or an immigrant, is approached by a mortgage broker or a contractor or anyone else with a product to sell, and they are offered a loan – a mortgage or a refinancing plan, typically – on terms they can barely afford. They are promised that the loan will pay for itself, either by lowering their credit card bills (consolidation) or increasing the equity on their house (in the case of home improvements). At closing… they find themselves pressured to sign documents they do not understand on terms far less favorable than promised.”

By the time the borrowers inevitably default, the lender will have bundled up the loan and sold it on.

Scurlock also lists some of the mortgage deals that were available in the vastly overinflated California housing market a couple of years ago. Interest only we all know about. We had those in the UK too. Another is 125% mortgage – by borrowing over the price of the house, you can use the extra money to make your mortgage payments. In theory.

Worst of all was the ‘stated income’ mortgage. For a fee, the bank would waive the checks on the income that you stated on your form. This meant you could say you earned $500,000 a year, and get a mortgage on a house you could never afford in a million years. It should be pretty obvious that if you create a ‘liar’s loan’, as it was called, you should expect people not to be able to pay. Sure enough, this kind of idiocy has brought down not just the banks that issued them, but all the banks that subsequently bought the passed on loans.

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