Bad Credit Finance

Sub-prime credit lending is an acceptable practice and can be highly lucrative for the lender because of the higher interest rates that they can be charged. These higher interest rates are a reflection of the risk taken by the lender for engaging in such a transaction. The bulk of people that fall within the sub-prime category have low incomes or have had previous bad debt, but just because a person has a poor credit history, it doesn’t necessarily mean that they are a bad payer, it could also mean that they don’t have any type credit history in the country e.g. in the case of immigrants, or that they have dealt mainly in cash for a long period e.g. street vendors. In the case of some divorcees, one of the spouses may have no credit history as debts may have been in the other spouse’s name. There are many reasons that exist as to why people should be allowed to take up loans and thus the reason for sub-prime lending’s.

In the conservative days prior to 1990, sub-prime lending was considered too risky by most banks, and very few sub-prime loans of a considerable value were granted. However, during the 1990’s, the economic environment had changed and a few key drivers started to emerge that would fuel the growth of sub-prime lending.

Firstly, the housing market took off. In the views of the banks, appreciation in this market had always been considered as irreversible, and thus it was a secure lending to make. With annualized increases of between five and ten percent, any bad lending could be recouped quite easily by foreclosing on the loan and securing the appreciated asset, which clearly would have a value greater than the outstanding loan amount.

With the majority of banks jumping on the sub-prime bandwagon, issuing loans against property started to become easier, as it was considered secure. Almost all sub-prime lending was done against a security of some sort and this started to result in leniency with regards to the lending standards, before long it had become the norm, and the banks didn’t really mind as they believed that they held no to little risk, in some cases loans were valued at 100% of the asset value.

Investors had a role to play in the banking sectors behavior and driving the sub-prime lending spree. Their constant demand for high yielding securities, fuelled an economic boom with regards to lending, which was traditionally capital constrained. The sub-prime lending was the banks answer in supplying these securities and the ratings agencies were in agreement as they had indicated through their ratings that the risk associated with the investment was less than reality, and they were duly allocated an investment grade rating.

Another driver that became popular in the 1990’s was the adjustable rate mortgage(ARM). This mortgage plan was beneficial in a positive economic climate where interest rates are falling. This product was particularly attractive to sub-prime borrowers as it was often marketed with an initial reduced interest rate. The concept of the product is that the rate attached to the mortgage would fall alongside the interest rates. However, if the interest rates begin to increase, as they did in the mid 2000’s, interest rates and thus the payments increase as well. From 2004 to 2007 interest rates increased by 4.25%, coupled with the expiration of the initial reduced rate offering, which resulted in borrowers being unable to pay back their ARM’s,

From 1993 to 2003, estimated debt increased from $33bn to $330bn, and by December 2007 sub-prime lending stood at an astonishing at $1.3 trillion, with an estimated 20% of all mortgage loans issued being sub-prime.

Sub-prime lending went bust in the late 2000’s and a lot of its appeal has now been lost. With the financial crisis, investors are not interested in the products to the same degree, but the concept still exists, for the same reason it always had. Residential properties were the greatest hit by the sub-prime fallout as property owners are forced to sell at lower prices, commercial properties have had limited exposure and maintain their long term value.