subprime lending

subprime lending, the practice of extending credit to borrowers with low incomes or poor, incomplete, or nonexistent credit histories. Subprime mortgage loans, the most common form of subprime lending, are characterized by higher interest rates and more-stringent requirements to compensate lenders for the higher credit risk involved. By providing credit to individuals who would normally be denied it in the standard (prime) mortgage market, subprime lending allows a larger number of households to create wealth over time through home ownership.

Subprime lending in the United States was not possible before 1980 because of state laws limiting interest rates. In that year the federal Depository Institutions Deregulation and Monetary Control Act (DIDMCA) eliminated such interest-rate caps, giving lenders the ability to charge higher rates and fees to risky borrowers. Two years later the Alternative Mortgage Transaction Parity Act (AMTPA) lifted restrictions on the use of variable interest rates and balloon payments. Although those two laws opened the door for the development of a subprime lending market, what made subprime lending viable on a large scale was the Tax Reform Act (TRA) of 1986, which allowed U.S. taxpayers to reduce their tax obligations by deducting interest on mortgages for primary residences and one additional home. The TRA caused a substantial increase in the demand for mortgage debt, because the tax deductions on mortgages made those instruments cheaper than other forms of consumer debt for many homeowners.

Increased consumer confidence during the economic boom years of the 1990s, coupled with low interest rates maintained by the Federal Reserve, generated a huge increase in subprime lending. Cash-out refinancings, in which a homeowner obtains a new home loan that is larger than the old one and receives the difference in cash, and home equity lines of credit became very popular. New techniques of mortgage securitization allowed lenders to easily package and sell mortgages and other debt contracts to investors in the form of mortgage-backed securities (MBSs), which helped lenders to reduce their costs and transfer risk. All of those developments contributed to the rapid expansion of the subprime lending market through the early 2000s.

The result was the creation of a housing bubble (a rapid increase in home prices to unsustainable levels) in the United States. When the bubble finally burst in 2007, the value of MBSs steeply declined, ruining the balance sheets of several major banks and investment firms and causing the subprime lending market to collapse. During the ensuing financial crisis of 2007–08 (also called the subprime mortgage crisis), nearly all lending froze in the United States, crippling the U.S. economy as well as the economies of countries in western Europe and elsewhere. The prolonged economic slowdown that followed, which came to be known as the Great Recession (2007–09), had its own catastrophic effects throughout the world.

The subprime lending market began a slow process of recovery after a series of drastic measures were implemented by governments and central banks around the world, including massive loans to financial institutions deemed “too big to fail.” (See Emergency Economic Stabilization Act of 2008.)