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What is the subprime market?

Ventsi Stamenov, portfolio manager and investment analyst at the Garrison Financial Institute in the Sam M. Walton College of Business, replies:

Subprime lending is the practice of making loans to borrowers with questionable or deficient credit history. To compensate the lender for the default risk associated with lending to borrowers with poor credit, subprime borrowers are charged a higher interest rate than borrowers with good credit ratings. Subprime lending is risky for lenders and borrowers due to the combination of high interest rates, poor credit history and adverse financial situations usually associated with subprime applicants.

The subprime mortgage financial crisis of 2007 was characterized by a rise in home foreclosures, which started in the United States during the fall of 2006. The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007. The share of subprime mortgages to total originations increased from 9 percent in 1996 to 20 percent in 2006. While U.S. housing prices continued to increase from 1996-2006, refinancing was available. However, once housing prices started to drop in 2006-2007 in many parts of the U.S., refinancing became more difficult. Mortgage lenders that retained credit or default risk were the first impacted, as borrowers became unable to make their mortgage payments.

Due to a form of financial engineering called securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit risk to third-party investors via mortgage-backed securities. Investors holding these securities faced significant losses, as the value of the underlying mortgage assets declined and payment streams became unpredictable. In addition, legal entities designed to isolate this risk from the originating lenders, called collateralized debt obligations and structured investment vehicles, held substantial amounts of mortgage-backed securities. As the value of payments into these entities declined, their value also declined, forcing the sale of these securities, sometimes at fire-sale prices.

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