Subprime loans are offered at a rate above prime rate to borrowers with weakened credit history unable to qualify for prime rate loans (Gilbert, 2011). Due to increased credit risk, and as such greater risk of default than prime loans, subprime loans are offered at higher interest (Federal Deposit Insurance Corporation, 2001). Subprime loans were considered a teaser loans as it allowed borrowers to qualify for the loan that they initially would not be able to. In addition, the appreciation of home prices provided a means to achieve profits (Watkins, 2011). As part of the housing expansions primarily due to declining interest rates, ease of qualifying for mortgage due to subprime loans, appreciation of home prices, housing market was flooded with investors. The opportunities offered from issuing subprime loans was too great to be passed and the growth of housing market made them seem riskless. Regular refinancing of subprime loans and prepayment penalties provided fees to the banks. Furthermore, by securitizing subprime loans and passing the risk to others, banks found these loans even more attractive. The process of securitizing subprime loans was very simple and posed no risk. The process of securitizing subprime loans involved banks creating the loans, then selling them to investment banks, and the investment banks would in turn package them into bonds and sell to other investors (Watkins, 2011). This process is known as “originate-to-distribute model and provided the means of wealth and increased cash flow for lending banks (Gilbert, 2011). Furthermore, if borrowers were to default on their mortgage payments, the banks would receive the value of the home which exceeds the loan’s value (Watkins, 2011). Thus, subprime loans meant profitable opportunities and new source of income, and subprime mortgage origination increased from $120 billion on 2001 to $625 billion in 2005 (Gilbert, 2001).
Contradictory to perceived assumption of subprime loans being riskless, there are many high risks associated with subprime loans. The main characteristic of subprime mortgage loans is that they had to be refinanced after two to three years at which point the interest rates will be much higher making it difficult for borrowers to maintain their monthly payments (Watkins, 2011). Watkins (2011), by citing Lewis, refers to subprime loans as a cheat loan as borrowers anticipated to be able to refinance at the easier terms. Furthermore, the attractiveness of originate-to-distribute model and incentives of selling the mortgage all contributed to lowering of underwriting standards. Thus, as home prices started to decline, and interest rates started to rise, defaults on the mortgage loans increased as borrowers were not able to afford to refinance. Therefore, the inability of refinancing and heavily investments of financial institutions in subprime mortgages, all contributed to subprime lending mess. Considering all these elements, subprime loans were referred to as the cause of recession and unemployment (Gilbert, 2011).
Federal Deposit Insurance Corporation. (2001). Expanded Guidance for Subprime Lending Programs. Retrieved from http://www.fdic.gov/news/news/press/2001/pr0901a.html
Gilbert, J. (2011). Moral Duties in Business and Their Societal Impacts: The Case of the Subprime Lending Mess. Business & Society Review, 116(1), 87-107. doi:10.1111/j.1467-8594.2011.00378.x
Watkins, J. P. (2011). Banking Ethics and the Goldman Rule. Journal Of Economic Issues, 45(2), 363-372. doi:10.2753/JEI0021-3624450213
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