Subprime Lending
Subprime Lending
(Bloomberg) -- Not that many years ago, subprime loans almost brought down the global economy. The financial world collectively vowed to never again go overboard advancing money to people considered unlikely to pay it back. But in the U.S., some forms of subprime are on the rise again, primarily in auto loans and also in small-business lending. That has some observers worried — and others calling for more such lending. Not all subprime loans are bad, they say, and it’s not just banks saying it. Consumer advocates want more people to have access to loans while economists see tight credit playing a big role in holding back economic growth. Maybe subprime mortgages are the medicine the economy needs. Or maybe subprime is such a slippery slope that we’re better off not going there. Is it possible to do just the right amount of risky lending?
The Situation
The subprime rebound was fastest in auto loans, although it’s still below its pre-crisis peak. In addition to handing out loans to more borrowers with low credit scores, U.S. auto lenders have eased terms by giving consumers as long as seven years to repay and allowing them to use use manufacturers’ rebates toward a down payment. Three of the largest auto lenders — Ally Financial Inc., Santander Consumer USA Holdings Inc. and Credit Acceptance Corp — have had to set aside more money to cover souring loans as banks have warned that the auto loan market is overheating. The number of delinquent car loans has risen and federal regulators have said it’s an area they're monitoring. Online lenders, after years of extending loans to small businesses that carried annual interest rates of 100 percent or more, are now undergoing a shakeout after getting burned by losses and struggling to secure sufficient capital. The picture is different, however, in home loans. Bank executives including JPMorgan Chase & Co.'s Jamie Dimon have said the massive increase in mortgage lending regulation has meant many first-time homebuyers have been locked out of the market. Even so, the return of bonds backed by bundles of riskier mortgages — now known as nonprime — has some regulators worried.
The Background
Almost since the dawn of civilization there have been tensions between lenders and borrowers. As early as 350 B.C., Aristotle said the petty usurer was “hated with most reason.” Shakespeare’s “Merchant of Venice” made the name of its antagonist, Shylock, into a byword for usury. The word subprime didn’t enter the popular lexicon until the 1990s. At the time, the term referred to credit scores below levels that qualified for prime, or conventional, loans. Definitions varied: the cutoff was sometimes set at 620 and sometimes at 650, roughly equal to the bottom 10 percent. Then, as the U.S. housing market heated up a decade ago, subprime took off. More subprime loans were securitized, that is, bundled together and sold to investors as the equivalents of bonds. Brokers and banks made fat fees for making loans, and investors collected higher-than-prime interest rates. That combination led lenders to make ever more loans to ever more stretched borrowers, with some of the riskiest and most costly loans peddled to blacks and Hispanics. A surge in defaults sparked the worst recession since the Great Depression. There have been more than 7 million foreclosure since the start of 2007; according to RealtyTrac, roughly 700,000 of those homes were purchased entirely with borrowed money.
The Argument
The financial crisis tarnished the idea that large-scale subprime lending is a social good that could promote the dream of homeownership for every American. The debate now is over whether lower-income households are better off with less access to credit, and how to balance the boost more lending would give to the economy against the risks of another meltdown. Some consumer advocates are calling for banks to loosen their underwriting standards, as long as it can be done without imposing ultra-high interest rates or punitive terms. In the meantime, online or payday lenders have entered the void. They are less regulated and are seen as more likely to take advantage of borrowers. After the recession, the increase in subprime auto loans helped the economy by contributing to a rebound in car sales, but rising delinquency rates have made some investors wonder whether the trend will end in tears once again.
The Reference Shelf
- The U.S. Financial Crisis Inquiry Commission’s report on the origins of the 2008 meltdown.
- A report by the New York Fed on the resurgence of subprime loans to car buyers.
- The New York Fed’s quarterly report on household borrowing.
- A series of articles from the St. Louis Fed in 2007 on subprime lending.
- A Wall Street Journal blog post discussing different definitions of subprime.
First published Sept.
To contact the editor responsible for this QuickTake: John O'Neil at joneil18@bloomberg.net.
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