Easy subprime – what is it and what has happened?

‘Subprime’ is probably the most used word in the media at the moment. In the business sections, you will probably see it there every day as banks announce losses and the US housing market continues to be hit by a huge scale of repossessions. It was even voted as word of the year for 2007 by the linguists of the American Dialect Society. However, you wouldn’t be the first person to question the meaning of the word, news articles normally report somewhere along the lines of: ‘the bank reported a write-down of $9.4 billion... because of losses from investments linked to US subprime mortgages that had gone bad.’ (BBC – ‘Morgan Stanley to cut jobs’). But what does that sentence mean? How did the mortgages go bad?

What is subprime?

The word ‘subprime’ refers to a lending practise whereby a lender gives a loan to a borrower who does not qualify for a good interest rate because of a poor credit history. In effect, ‘subprime mortgages’ refers to lending mortgages to people with bad credit.

How did they 'go bad’?

The beginning of the subprime mortgage crisis has its roots to all the way back in 2001, when the US economy was first hit by the dotcom bubble crash and then September the 11th. In the wake of this the US Federal Reserve dropped interest rates to 1 per cent, making borrowing cheap as the US housing market began to boom. Many mortgage lenders thought they saw a particularly lucrative market by lending to subprime borrowers, i.e. people with adverse credit, because they would be able to charge higher interest rates for the riskier customers.

As house prices continued to increase until 2006, refinancing these mortgages through homeowner loans or remortgaging was relatively easy. However, house prices had risen sharply along with interest rates, and by the end of 2006 house prices began to deflate. Soon the US housing bubble popped and house prices slumped, leaving many people unable to refinance due to negative equity in their property. People began to default on their mortgages, which simply meant that they couldn’t pay. Many houses were repossessed as a consequence.

How did the banks lose out on this?

A sizeable chunk of mortgage lenders who leant to subprime borrowers repackaged their debt as mortgage backed securities (MBS). The cash flow of these is backed by the principal and monthly interest payments of mortgages. Because of the boom in the US housing markets, many banks and hedge funds saw MBSs as good investment opportunities. However, when the cash flow on them stopped due to borrowers defaulting, the securities lost their value, resulting in huge losses for those that had invested in them. So far, some $130 billion of investments have been written off, while the whole crisis is having a knock on effect into credit markets and the wider world economy.