Published July 1, 1999 | July 1999 issue
Subprime lending involves the extension of credit to borrowers with poor or minimal credit histories. Over the last 10 years it appears that the amount of subprime lending has grown. It also appears as if federally insured banks have entered the subprime market in greater numbers. Both trends have put subprime lending in the spotlight and reaction by policymakers, regulators and analysts has been mixed.
Subprime lending represents a technological advancement that increases the availability of credit and could improve the allocation of financial resources. However, society should be concerned when federally insured banks engage in a practice that has led to failure and significant financial distress of many firms. Society need not necessarily be concerned that subprime borrowers are taking on too much debt or are paying rates that are inherently too high. These concerns should be taken seriously if current pricing and borrowing amounts arise from poorly functioning markets or unfair/illegal practices, but should be treated more skeptically if they simply represent the imposition of some observers' values on subprime borrowers.
Subprime loans are characterized by several features. The recipient of the loan has blemishes or very little data on their credit record indicating, for the most part, an increased probability that borrowers will not make good on their obligation. The loans also come with relatively high rates of interest and/or fees. Some subprime auto lenders charge their riskiest borrowers annual percentage rates of 20 percent or higher. Finally, these loans usually require intensive levels of servicing and collection efforts to ensure timely payment.
These generalizations should not hide the fact that subprime lending is not a term applied consistently. For example, one lender may classify all borrowers who have ever been bankrupt as subprime while another makes the determination based on the cause of bankruptcy. In addition, loans that were considered subprime in the past may not warrant that designation in the minds of some lenders today.
This ambiguity makes gauging the size of the market difficult. There is no regulatory or other central body accumulating data on subprime lending, but more ad hoc attempts at collecting information on subprime lending suggest a sizable increase in the market. By some estimates, the subprime auto market has grown nearly fourfold over the last decade (from about $15 billion in loans to $65 billion) while the subprime mortgage market nearly doubled from its size in 1995 (from $290 billion to $415 billion). Insured banks are also believed to have become much more active participants in the subprime market through in-house efforts or purchases of subprime specialists such as the Money Store.
A recent Federal Reserve Bank of Minneapolis survey sought to gather information on the prevalence of subprime lending among the smaller institutions that make up the vast majority of commercial banks in the district (see a description of the survey). A relatively large percent of district banks (29 percent of respondents) said they are currently offering loans to low-credit quality consumer borrowers (that is, subprime). Of course, these answers do not imply that subprime lending is a focus for these banks. Indeed, statistical analysis indicates that these banks did not have characteristics suggesting that they are deeply involved in subprime lending. In addition, the largest banks with a presence in the district are also involved in subprime lending to various degrees. For example, Community Credit, a subsidiary of Norwest Finance Co., is a sizable nonprime auto lender, and a subsidiary of Norwest Mortgage also makes subprime mortgage loans. US Bancorp purchased a stake in a subprime mortgage lender in late 1998.
In any case, the growth in subprime lending has raised what may appear to be a surprisingly mixed reaction. Federal Reserve Board Chairman Alan Greenspan captured this ambivalence in 1998 noting "... there has been a boom in so-called 'subprime' lending ... improved access to credit for consumers and especially these more recent developments reflect a good news/bad news story." (From remarks entitled "Economic development in low- and moderate-income communities," Community Reinvestment and Access to Credit: California's Challenge, Los Angeles, Calif., Jan. 12, 1998.)
The growth in subprime lending is good news in that it reflects an increase in the availability of credit for populations who may have previously had more limited borrowing opportunities. This increase reflects important aspects of the technological revolution in financial services more generally. Most importantly, the increase in computing power along with the decrease in its cost make it feasible to obtain, analyze and store data on subprime borrowers on a much larger, more sophisticated scale than was previously possible.
Advances in communication make it possible for subprime lenders to centralize aspects of their underwriting and collection efforts, for example. This allows lenders to apply consistent underwriting standards to a large, national portfolio of loans and use systems that can increase repayment prospects, such as predictive dialing systems that target borrowers when they are most likely to answer the phone. Finally, financial technologies that expedite the sale of consumer loans in capital markets allow subprime lenders to fuel their growth.
In this context, subprime borrowers are the beneficiaries of a dynamic sector of the American economy that was able to evolve and meet a market demand. The "market specialization, competition and innovation" that have led to the expansion of credit to virtually all income classes should make it possible, as Chairman Greenspan notes, "to help families purchase homes, deal with emergencies and obtain goods and services that have become staples of our daily lives."
The vigorous growth in the subprime sector has come with financial troubles on a significant scale. Chairman Greenspan has noted that, "some loans to low- and moderate-income families ... have been showing unfavorable delinquency trends." More dramatically, Moody's reports that there have been at least 11 bankruptcies of subprime auto lenders. There have also been a relatively large number of firms that have exited the business because of poor financial results, as well as acquisitions of firms that may not have survived on their own. The subprime mortgage industry has also gone through a rash of business failures in 1998 and 1999. Of course, delinquencies and business failures, in general, are not inherently bad. Indeed, the decrease in on-time payments is not unexpected given an increase in subprime credit.
A policy concern arises, however, when insured institutions increase lending that could pose a higher risk of loss. In fact, the government's insurer of deposits has specifically identified subprime lending as a risk to the health of the banking system. While the failure of a finance company that makes subprime loans is important to its creditors, employees and maybe even its borrowers, its insolvency is normally viewed as part of the ebbs and flows of a free market economy rather than an issue of public interest. In contrast, the government insures depositors and makes payments to them upon the failure of their bank. The public thus has reason to worry when banks take actions that increase the likelihood of failure.
Bank regulation is the primary tool used to limit bank risk taking, and regulators have issued guidance to banks and examiners on the potential dangers of subprime lending, which captures the difficult task that regulators have in determining how much risk taking is too much (go to minneapolisfed.org for Web links to this guidance). Subprime lending has proven to be a profitable and safe business for lenders with strong management, well-conceived risk management, controls and operations, and pricing that accounts for the risks the bank takes. Yet, subprime lending clearly requires banks to take on credit risk that many had previously shunned. The failure-strewn subprime market provides ample evidence that without proper controls, success can be elusive.
Regulators thus face a balancing act. One method for helping regulators determine what constitutes excessive risk taking is the selective incorporation of market assessments of bank risk taking into the supervisory process. This Reserve bank recently offered a reform plan to achieve that goal (although the focus of this plan is the largest banking organizations, not necessarily those engaged in subprime lending.)
Some observers of subprime lending have also expressed concern about the high rates that subprime borrowers face, and more generally the potential that subprime borrowers will wind up with more debt than they are capable of repaying. In any discussion of consumer borrowing a bright line must be drawn. Regulators and other authorities should respond with full legal force against deceptive, fraudulent or discriminatory practices. But, the justification for limiting borrowing because the cost is more than some observers would willingly pay, or the amount borrowed strikes these observers as "too high," could be more troubling.
As long as markets are competitive, a very high interest rate may be appropriate given the chance of default that some borrowers pose. Indeed, attempts by policymakers to broadly limit fairly set rates charged by financial institutions to certain borrowers, even if expressed informally, could have unintended consequences. Such restrictions or jaw boning could reduce the total amount of credit offered to lower credit quality borrowers or force those subprime borrowers to less regulated lenders who can charge even higher effective rates. Attempts to figure out how much debt someone should take on could put society in an even more awkward position. Should society then decide how much subprime borrowers should spend on clothing, cars or housing? Should subprime borrowers be given fewer choices than prime borrowers?
Although the data is limited, it appears as if lending to those with subpar credit quality has increased over the last several years. This trend results, in part, from a decade of profound revolution in financial services. However, subprime does come with a potential downside for society to the degree to which government insurance pays the cost for poorly managed risk taking by banks.