Prior to the 2007 credit crunch that rocked the financial world, the term “sub prime lending” was unheard of. This is not to mean that this practice did not exist before. It is just that many people became aware of it at this time. It is the practice of financial institutions availing credit to people who do not meet the qualifications required by the mainstream or the so called prime lenders. Mainly, these credits are advanced to borrowers who has a “FICO score below 640” (Gordon, 2009: 1). As a rule, these types of credits are expensive to the borrower and risky to the lender. However, the lender, despite the risk that is associated with this form of lending, stands a greater chance of getting a good return if the borrower gets to settle the debt. This is because the lenders usually increase the interest rate way above the ones charged by the prime lenders in order to cover for the risk.
This research paper is going to look at the rise of the sub prime lending in the mortgage industry. There are many types of sub prime lending. These include auto loans and credit cards. However, the writer will concentrate on the mortgage credit given the fact that it is one of the most common and most risky sub prime lending. The author will be interested in examining whether sub prime lending is a viable business model for a lending institution.
Research Questions
The broad objective of this research will be to examine the viability of sub prime mortgage lending business model for a lender. To achieve this, the writer will be guided by the following research questions:
1. What are the benefits that are associated with sub prime lending in mortgage?
2. What are the risks associated with this form of business model?
3. What are the major characteristics of sub prime borrowers?
4. Despite the risks that are associated with sub prime lending, why do business still engage in this form of business practice?
5. Who are the major gainers and major losers in the sub prime mortgage lending industry?
6. Which measures can a sub prime mortgage lender take in order to ensure that risks are averted and at the same time benefits accrued?
Sub-Prime Mortgage Lending: A Viable Business Model?
Many people have questioned the viability of this lender’s business model in the light of the current global credit melt down. This is given the fact that this is a very risky venture that, despite the higher returns it can bring to the investor, needs to be approached cautiously (Ferguson & Hartmann, 2007 p 154: Schiff, 2008 p 249: Kirchoff & Block, 2008 & Roubini,2006). Many lenders are trying to struggle with the question of whether to embark on this business model or to shun in totally.
With the current global economic meltdown, sub prime mortgage lending is not a viable business model for any lender. This is because the borrowers of these credits stand a very high chance of defaulting on their repayments (Sabry, Sinha & Lee, 2009: Watkins, 2009 & BBC News, 2007). Even before the economic meltdown began, these borrowers were defaulting by as much as 25% in 2006 (Zandi, 2009 p121). If this was the case, there is no reason to believe that these people will be able to repay their loans now with the decreased incomes experienced by many people today. Also, these people have a history of either loan defaults, fore closures, bankruptcies or lack of assets which makes them unsuitable to borrow from the prime borrowers. It is not logical for a business executive to hope that a person who had been unable to finance loans when the economy was doing well will be able to meet the same target in a situation where the interest rates have been raised and the economy has taken a nose dive (IMF, 2009 p 187).
Many businesses that had invested heavily in sub prime lending especially in mortgage are either facing closures today or have already closed down (eFinance Directory, 2009). This has been brought about by the declining of the housing market in major economies like the US and Britain (BBC News, 2007). Real estate market in America, where majority of the sub prime borrowers had invested, came tumbling down in the start of the year 2007-2008. This led to many closures as the lenders were reeling from defaulting borrowers. Accredited Home Lenders Holding “saw more than 75% wiped off its value in two days” (BBC News, 2007). HSBC accrued toxic debts of around $10.5 billion as a result of defaults by mortgage borrowers (BBC News, 2007). This was in the year 2006. If anything, matters have only gotten worse since that time. This means that if such giants could fall by the way side, then this is a venture that should be averted by any business that wishes to weather this economic crisis.
Many people are speculating that we have seen the worse of this economic crisis. What they are alluding to is that it is perfectly safe now to venture into risky undertakings because things cannot get any worse. This is speculation. A prudent business executive should never embark on a venture based on speculations. This is like gambling. One might start lending sub prime mortgages, only for the property prices to plummet further (Adverse Mortgage Centre, 2007). In the year 2006, New Century Financial was of the view that housing prices could not go down any further. However, they were proved wrong when by the year 2007-2008, the prices have tumbled by more than 50% (Barth, Li, Lu, Phumiwasana & Yago, 2009 p 389). This is an indication that this is not a viable model to be adopted by any lending business at this time.
Conclusion
There are many reasons that make sub prime mortgage lending an unviable business model for lending businesses at this time. This includes the reduced income that is available to many people today, plummeting house prices and spiralling interest and inflation rates. What this means is that people are more likely to default in their payment leading to toxic debts and ultimate closures. But this does not mean that there are no benefits for those bold lenders who invest in sub prime mortgage lending. Returns are very high, considering the fact that interest rates for these loans are as high as 50% above the prime rates. There are also many people out there who have the ability to repay loans but cannot access the prime ones for several reasons. These reasons range from past defaults and bankruptcies in the past. These people have probably experienced financial upturns but they cannot access mortgage. Investing in these people will be prudent as they will be able to repay the loan.
References
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The author of this article is a holder of Masters in Business Administration (MBA) from Harvard University and currently pursing his PhD Program. He is also a professional writer of http://researchpapers247.com
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