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
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
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
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
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.