Definition Of Subprime Lending
The proper definition of subprime lending has several aspects. Federal banking agencies define a subprime loan as one which is made to a borrower with a weak credit history or less of a capacity to repay. There is no single subprime mortgage lenders list which categorizes specific lenders. In fact, such lending is not confined to mortgages. For example, several other areas of the industry are involved with credit cards and car loans, or with certain investment properties.
In a general sense, though, the definition of subprime lending is lending at a higher interest rate to a customer who for some reason is not able to qualify for a prime rate loan. This is often associated with a person who has a poor credit rating, or who has outspent their credit card limit. However, it also encompasses those who have not acquired a sufficient credit history. Perhaps an individual has low income or a poor debt-to-income ratio. A loan may be large compared to the property which secures it (high loan-to-value ratio). The increased risk associated with such loans in each of the above scenarios means that the cost of borrowing is greater for the lender, and is passed down to the client in the form of higher interest rates.
Another part of the popularly understood definition of subprime lending has a more sinister aspect. Because customers involved in such lending are often in urgent need of additional funds, they may believe that they do not have the time to search for the best deals on their loans. Maybe they do not even know how to go about doing so. This is unfortunate, considering that it is not difficult to locate a subprime mortgage lenders list and find a responsible lender by using an Internet search. These customers are especially targeted by scam artists who seek to capitalize upon the borrower's desperation.
By manipulating loans with high interest rates, 'interest-only' requirements, sudden balloon payments or hidden costs, these criminals seek to use the client's situation for their own financial gain. Choices of products offered may be limited, and the loans structured in such a way that a customer who does not have an understanding of financial matters may be tricked into accepting a loan which the lender knows is inappropriate and doomed to result in failure. These types of lenders are characterized as predatory. They certainly provide a modern example of the ones in Amos 2:6-7, who ...sold the righteous for silver, and the poor for a pair of shoes; That pant after the dust of the earth on the head of the poor, and turn aside the way of the meek... Some lenders have also been accused of discrimination with regard to the assignment of mortgages or other loans on the basis of race.
Painting all subprime lenders with this brush would be a matter of throwing out the baby with the bath water. Proponents of such lending believe that the industry is providing a service to people who would otherwise be excluded from the market entirely. These proponents would argue that predatory lenders do not fit the true definition of subprime lending. They would say that such predators are not just the black sheep of the subprime lending family, but wolves, and should be prosecuted and excluded from any subprime mortgage lenders list. One problem with this proposal is that it is sometimes difficult to prove the motivations behind actions, especially in a legal sense. Where is the line between a 'black sheep' (who may need to be corrected and yet has hope of restoration), and a wolf who needs to be punished and driven away?
Federal banking agencies view predatory lending as an aspect of subprime lending which tends toward abusive practices. Predatory loans seem designed to transfer wealth from the borrower to the lender, without giving anything in return. Thus, the originators of these loans make their decision based on the borrower's assets rather than whether he or she can repay the money. Deception is also used to obscure the full terms of the loan from those who are not knowledgeable about financial matters. Furthermore, the predatory loan dealer may try to convince the borrower to refinance over and over again, in order to collect additional fees.
The Community Reinvestment Act (CRA) attempts to provide some guidance as to the definition of subprime lending as it relates to banking practices. Three purposes of the Act are to encourage banks to make more loans in their communities (particularly to persons at lower income levels), to make sure that these loans meet the credit needs of the community (best possible terms and affordable credit), and to practice sound banking procedures as they do so. The CRA issues four levels of ratings for financial institutions: 'outstanding', 'satisfactory', 'needs to improve' and 'substantial noncompliance'. There is some differences in requirements for banks with different levels of assets.
Predatory lending obviously violates most of the above conditions, and banks or other financial institutions which evidence such behavior are assigned a lower rating. Lenders without such predatory behavior may still have problems in certain areas, such as guarding against racial discrimination or the tendency to push subprime instead of prime-rated loans. At times there is a rather mixed bag of results, for these same subprime lenders can help a bank meet its responsibility to provide services for lower income customers. Most recommend keeping better oversight of lenders, while recognizing the need to halt the activities of predatory lenders. Some websites are available which provide lists of available lenders in the prime rate market, as well as a subprime mortgage lenders list. These sites can offer substantial amounts of information on hundreds of lenders, as well as the services they provide. Information, whether from ratings by federal banking agencies or on private websites, may prove to be the most significant weapon for consumers to use in fighting against improper lending practices.
Collateralized Debt ObligationWhat is the relationship between collateralized debt obligation and sub prime mortgage loans? Although it is true that the two are intertwined, the apocalyptic economic scenarios which dominate the headlines today may be somewhat overstated. Some people seem ready to throw in their investment towels, resigned to inevitable and cascading losses. No person can predict the future, of course, but perhaps a closer look is warranted before giving way to hysteria or rushing to liquidate assets.
First of all, a general understanding of sub prime mortgages is necessary. Sub prime lending involves financing loans to those who may have trouble meeting conventional loan requirements. Some may have a low credit score, or excessive debt. Others may have even more serious credit issues, like foreclosures and bankruptcy, on their records. Sub prime mortgage loans are available for these types of borrowers, but due to the increased risk involved in these loans, higher interest rates or additional fees may be imposed. Also, there may be stricter requirements in the loan to value ratio. In other words, one may get less loan money in return for the value of the property held as collateral. Surprisingly, the requirements for income documentation may actually be less stringent for these loans than for a conventional loan. Some borrowers with income which is difficult to document may find it necessary to pursue one of these loans, even if their credit is good.
Next, a brief overview of collateralized debt obligation would be helpful. Collateralized debt obligations (CDOs) were first issued in the 1980's, and became a growing sector of the securities market. These investments are put together in a wide variety of ways and are made up of different assets, but the principles behind a CDO remain essentially the same. Assets (such as mortgage-backed securities, high yield business loans, etc.) are held as collateral in a special purpose vehicle (SPV) and the cash flow from the investment is distributed to the investor. The SPV issues different classes of bonds and equity. There are several tiers(tranches) of investors, ranging from senior tiers which are designed to have little risk, to the lower rungs, which have a far greater potential of loss. The returns on the investment are designed to correspond to the level of risk; lower tiers receive higher rates of return to compensate for the risk involved. The senior tranche receives less return, yet is paid first from the cash flow.
The collateralized debt obligation is different from a regular mortgage or mortgage-backed security because investment is actually made in this cash flow rather than in the asset itself. There are different levels of risk and reward, yet the same portfolio of securities generates the cash flow. In a sense, then, the investor is relying on (or investing in) their belief in the system or mathematical model which is behind the construction of the various tranches. One factor in the growth of CDOs was the development of the Gaussian copula model by banker David Li in 2000. He came up with a computerized model to determine whether a given group of companies would default on bond debt one after the other. Interestingly, the model is based on a concept known as the 'broken heart'. Actuaries noticed that at times there is a correlation between a death of a spouse and his/her partner, where a person is more likely to die soon after the death of a beloved spouse. Mr. Li saw default as the 'death' of a company, and used these principles to come up with a model which made pricing collaterallized debt obligations faster and easier. Li's model used copulas, particularly one named after Carl F. Gauss, a 19th century German statistician. Copulas are mathematical models which predict the likelihood of events occurring when these events are interrelated.
Using this Gaussian copula model, investors can estimate risk and return, and devise strategies accordingly. If there is a high default correlation (high likelihood that all the companies in a particular sector will have losses at once), the difference between returns for risky vs. conservative investments might be small. However, if the pool of bonds had a low risk of default (low risk of the companies suffering losses all at once) the spread could be wider. Huge amounts of money are invested using this model or its variations. Even though this system has resulted in market growth, it is not foolproof. Investors who use such models without fully understanding them may think that they have taken sufficient precautions against loss when actually the system guarantees nothing. Not only are such investors suffering loss, but also there may be collateral damage to other markets which can trigger a loss avalanche.
How does this all relate to sub prime mortgage loans? Well, such sub prime mortgage debt is often a significant part of the investments bundled together in a collateralized debt obligation. Some large investment firms had great fortunes tied up in securites based on sub prime mortgage loans. In fact, one well known firm's recent collapse (even after assistance was given by the Federal Reserve) seemed due to the sub prime mortgage loan crisis which devalued its assets. Some believe that the government should not be involved at all in giving assistance in such matters, while others want the government to purchase foreclosed properties in order to stop falling housing prices. Others warn of upcoming waves of foreclosures and look for interest rate cuts. The government points to the many people already assisted by current programs and awaits the impact of billions of tax rebates due in upcoming months upon the economy. The uncertainty of future events provides a bleak background against which the light of God's Word in I Timothy 6:17 shines even more brightly: Charge them that are rich in this world, that they be not highminded, nor trust in uncertain riches, but in the living God, who giveth us richly all things to enjoy... That is a model which will never fail.