What Are Subprime Mortgage Loans?

Subprime lending involves extending credit to higher-risk borrowers, a practice often categorized as "B/C" or "nonconforming" credit. This type of lending targets communities that have historically been underserved by traditional financial institutions. In recent years, the subprime mortgage market has expanded significantly, with over 90% of all subprime mortgage loans issued since 1993. By the end of 1996, the total value of outstanding subprime mortgage loans had surpassed $350 billion. In 1997 alone, subprime lenders originated over $125 billion in home equity loans. Subprime loans have increasingly become a substantial segment of the home equity market, with their share growing from 11.5% in 1996 to 15.5% in the first half of 1997. Concurrently, the market has seen a shift in the composition of lenders, with large, nationwide corporations becoming prominent players in the subprime sector.

The growth of the subprime mortgage market is driven by its profitability, increasing borrower demand, and expanding secondary market opportunities. Lenders typically charge higher interest rates and fees on subprime loans compared to conventional loans to compensate for the greater credit risks associated with these borrowers. Critics, however, argue that some subprime lenders impose excessively high rates and fees, which may be more than necessary to cover the increased risk, particularly as these loans are secured by property value. It is suggested that federal deregulation of state interest rate ceilings in 1980 has contributed to the higher rates seen in first mortgages.

The substantial profit margins in the subprime mortgage industry have attracted significant interest from investors seeking higher yields in a low-interest-rate environment. In 1996, the subprime mortgage sector issued over $38 billion in securities, marking the largest increase in securitizations for any lending sector that year. The growth of the secondary market has facilitated further expansion in the industry by enabling lenders to raise capital for increased subprime lending activities. Notably, Freddie Mac, a major government-sponsored enterprise, announced plans to enter the subprime secondary market, intending to purchase substantial quantities of "A minus" subprime mortgages by 1998 and "B and C" loans by 1999.

The subprime loan market is anticipated to continue its expansion. Rising credit card delinquencies and record levels of personal bankruptcies are adversely affecting borrowers' credit histories, pushing more consumers into higher-risk categories. At the same time, robust consumer spending supports the demand for subprime loans. Additionally, changes in the tax code, which limit interest deductions to first mortgages, may increase the appeal of home equity loans, further contributing to the growth of the subprime lending market.