The Sub-prime Market

The recent Sub-prime Market meltdown has brought the sub-prime market segment in focus. Foreclosures or closing out the sub-prime mortgage before its due date has skyrocketed urging the financial world to take a critical look at the whole segment.

The Development of the Sub-prime Mortgage Market

As has been dealt with in the earlier sections, sub-prime loans are mainly made against mortgages that do not have strong credit history and are perceived having high credit risk and consequently higher risks of default. This type of credit first emerged almost two decades ago, however it was only in the middle of the last decade the spurt in this segment was seen. This was mainly due to the emergence of various financial innovations like different derivative products that aided the growth by bringing down costs for lenders of appraising the risks. Moreover, development of new techniques for using information and setting underwriting standards and manage risk acted as catalysts.

However, apart from developing the primary market in which lenders disperse sub-prime mortgage loans to the borrowers directly and getting the interest payment as income, the secondary market also slowly evolved. In the secondary market securities having these sub-prime loans as collaterals are traded. In effect this means securitization of the sub-prime loans. These are then sold and the seller getting funds to replenish his own and again lend.

The buyer of these securities gets the interest due on the loans directly. In other words the interest is passed through by the originator or the lender at the beginning to those who have bought the securities having sub-prime loans as collaterals. This has given more impetus to the innovations.

Of course over the years the regulatory framework changed to help lenders easily sell mortgages to financial intermediaries. These financial intermediaries play a very vital role as they pool mortgages and securitize them by selling the cash flows. Thus these types of derivative products offer different risk profiles and durations for meeting different investment needs of various investors. This growth of the secondary market has given the mortgage lenders access to the capital markets, lowering transaction costs and managing risk better. Thus facilitating supply mortgage credit to the households.

These are the factors that acted as the foundation for the expansion of the segment over the past decades. However, although the growth has followed an upward trend but it has not been a uniform growth all through. The phenomenal development of this segment has helped a lot of people to own homes which in normal circumstances they would find hard to own as they do not qualify for conventional mortgage norms. In fact homeownership by minorities and households with lower income has gone up manifold. This has helped in building wealth and its better distribution. However it’s not an unmixed blessing as is seen in the recent past.

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