Subprime refers to those creditors who cannot be considered as "prime" lenders, because their credit status does not allow the bank to assess their creditworthiness as "prime". Subprime credit refers to various credit tools: credit cards, mortgages, and consumer credit.
From a technical point of view, a subprime creditor has a credit score lower than 620, according to the definition given by the US Federal Reserve. The low credit score can be the result of a bad credit history, or of its absence. The opportunity to lend to sub-prime creditors allows the bank to earn higher fees and interest rates.
Thanks to subprime mortgages, nine million US families were able to buy a house during the period 1996-2003 (Gramlich, 2004).
In 2007, it was estimated that the subprime market reached US$1.3 trillion, when the entire US mortgage market reached around US$10 trillion.
Subprime credit was allowed by the US Federal Reserve, out of prudential banking regulation, because of the special function this credit plays. In particular, this credit plays the function of social housing (through Fannie and Freddie), which is absent in the US.
Subprime credit should give free access to credit without any risk-weighting component (on assets owned by the bank). Other similar initiatives, like the credit to low-income students and micro-credit, play the same function, but they guarantee far smaller returns for intermediates. After 2006, critics to the subprime system soared because of the real estate market crisis, which increased the delinquency rate. The subprime credit is characterised by a very high negative correlation between real estate prices and delinquency; when prices start to slow down, delinquency accelerates. As observed by the Fed, after real estate prices started to slow down, thousand of families lost their house, contributing to the difficulties of the credit system. The critics to the subprime system argue that certain predatory practices have been allowed, regardless of the concrete ability to pay back credit. Some mortgages produced an amount of interests far exceeding the income of households, without any possibility to re-negotiate the debt. These practices are against any prudent and wealthy management of the credit system, which is the objective of the US Federal Reserve.
Editor: Chiara OLDANI
© 2010 ASSONEBB