What is Subprime Lending

Financial markets

Rainer Sommer

Rainer Sommer is a freelance business journalist and author specializing in international financial markets.

The crash on the US real estate market is considered to be the trigger for the global financial crisis. In the course of the subprime crisis, the banking practice of securitization became known to a broad public: with the help of rating agencies, risky loans were sold as a top investment.

The headquarters of the US investment bank Bear Stearns 2008 in New York. In the wake of the financial crisis, Bear Stearns went bankrupt and had to be financially supported by the US government. JP Morgan took over the institute. (& copy picture-alliance, AP Photo)

introduction

The “subprime” crisis is considered to be the trigger for the global financial and economic crisis of 2008/09, with “subprime” standing for a special segment of the US credit market. Affected are mortgage loans to finance a home that were given to debtors with poor credit ratings. It was therefore not a question of first-class “prime” customers, but rather more problematic borrowers who were therefore also charged higher interest rates - “subprime”. Later these debtors were derisively referred to as “ninjas” for “no income, no job, no assets” - no income, no job and no assets.

Real estate loans were at the center of the subprime crisis, which is considered to be the trigger for the financial crisis. (& copy AP)
From the point of view of the lenders and brokers, this new customer group opened up enormous earnings potential. In the prime segment, on the other hand, the credit market was largely saturated, which led to fierce competition among providers and low profit margins. The newly developed "subprime" segment, on the other hand, promised rapid market growth and extremely high profits in the short term.

Nevertheless, it should have been clear from the outset on the financial markets that many of these borrowers would run into difficulties at the latest if the interest rates, which were usually very low in the first few years, were raised in accordance with the contract. However, this was countered by the fact that even if the debtors could no longer pay their installments, the creditors would still have the real estate with which the loans were secured. This view was supported by the historical experience that since the Second World War there had been isolated price falls in regional real estate markets, but never in the whole of the USA. The lenders would only have to ensure a broad regional spread of the loans they grant in order to control their risks.

The US mortgage financier Freddie Mac was nationalized in the summer of 2008. (& copy AP)
Borrowers were mainly lured into the loan agreements with so-called "teaser rates", in which mostly no repayments and often not even interest were required for two years. For the time after the low interest phase of the contract, however, the prospect of simply rescheduling the debt was promised, since the meanwhile increased value of the property would allow an increase in the loan amount. Then the now very expensive old loan should be repaid and a new, cheaper one should be taken out, which again should only provide the debtors with very low monthly burdens.

However, the first experts warned of a rapidly growing real estate bubble in the USA as early as 2001 and real estate prices actually peaked in mid-2006 and began to drop rapidly a little later. This made this business model obsolete and the unsightly background of the subprime boom quickly came to light.

The first major US mortgage banks went bankrupt in early 2007 and the crisis reached its first climax in February 2008 with the failure of the powerful Wall Street investment bank Bear Sterns, which was taken over by the major bank JP Morgan with state aid. The crisis deepened over the summer, leading first to the nationalization of the gigantic and state-sponsored mortgage banks Fannie Mae and Freddie Mac, and in the fall of 2008 to the collapse of the investment bank Lehman and the world's largest insurer, AIG, and subsequently almost the entire western financial sector.

Political and regulatory requirements

Probably the most important prerequisite for this massive derailment of the financial markets was that both the government of President Bill Clintons and the subsequent administration under George W. Bush had set themselves the goal of making the home, which traditionally belongs to the "American dream", accessible to low-income sections of the population close. For this purpose, mortgage payments were tax-favored compared to rental expenses and various public programs were launched to help “subprime” borrowers to obtain mortgages.

The private loan providers were also granted tax breaks. What turned out to be an absolute disaster, however, was that the Clinton administration first refrained from regulating the booming market for financial derivatives and the Bush administration later took the position that any public regulation hindered the economy and therefore renounced even the existing ones Monitor rules.

In contrast, the government relied on the "self-regulation" of the markets. In line with the dominant neoliberal economic theory, it was assumed that the lenders would ensure themselves not to lose their funds, which turned out to be a serious mistake. One reason for this was that the Anglo-American financial markets had long been more geared towards capital market financing than, for example, the continental European financial market. In Europe, for example, normal bank loans dominate, in which a bank takes in savings and issues loans that it keeps permanently on its books. As a result, the bank is motivated to be very careful when granting loans, after all, all losses are later borne by it. In the USA, however, the lending business is predominantly "securitized" on the capital markets.