Our readers have mailed in asking us to write something on what 'subprime lending' (the thing that's causing all the current nervousness in the markets) is all about. So, here goes.

Subprime lending, also known as 'B-paper', 'near-prime' or 'second chance lending', is a term that refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history. Subprime loans or mortgages are risky for both creditor and debtors because of the combination of high interest rates, bad credit history, and the murky financial situations often associated with subprime applicants.

A subprime loan, which could be a mortgage, car loan or even a credit card debt, is, by definition, made to someone who could not qualify for a more favourable rate. Subprime borrowers typically have low credit scores and either a limited credit history, or histories of payment delinquencies, charges-offs or bankruptcies. Because of the risks associated with this form of lending, a subprime loan may come with higher interest rates, regular fees or an up-front charge.

Generally, subprime borrowers will display a range of credit risk characteristics that may include:

Two or more loan repayments paid past 30 days due in the last 12 months, or one or more loan payments paid past 60 days due in the last 36 months;

Judgment, foreclosure, repossession, or non-payment of a loan in the prior 24 months;

Bankruptcy in the last 5 years;

A relatively high default probability as evidenced by a low credit bureau risk score.

Some subprime lenders have increased their loan production and servicing income by securitizing and selling the loans they originate in the asset-backed securities market. Strong demand from investors (fund managers, investment banks, insurers, hedge funds, etc) and favourable accounting rules often allow securitization pools to be sold at a gain, providing further incentive for lenders to expand their subprime lending program. However, the securitization of subprime loans carries inherent risks, including interim credit risk and liquidity risk, that are potentially greater than those for securitizing prime loans. Accounting for the sale of subprime pools requires assumptions that can be difficult to quantify, and erroneous assumptions could lead to the significant overstatement of an institution's assets.

The recent turmoil in the financial markets illustrates the volatility of the secondary market for subprime loans and the significant liquidity risk incurred when originating a large volume of loans intended for securitization and sale. Investors can quickly lose their appetite for risk in an economic downturn or when financial markets become volatile. As a result, institutions that have originated, but not yet sold, pools of subprime loans may be forced to sell the pools at deep discount (and there may be no takers). And institutions that have acquired the assets via a securitization may find that the pool is difficult to value, and that liquidity disappears in the event that pools need to be sold.

Sources - Wikipedia.com, The US Federal Reserve

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