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What are subprime mortgages?

What are subprime mortgages?During the credit crisis we've heard a lot about subprime mortgages, but what are they and why are they being blamed for a financial downturn?

Subprime is an expression used in the US. It usually refers to a subprime mortgage, a loan given to borrowers whose credit history is not reliable enough to get a normal mortgage. Often these borrowers have a history of "bad credit". This may range from a simple late payment, to several defaults and even bankruptcy. In the UK, we were more likely to talk about the adverse credit or bad credit mortgage sector.

More risk, more money

This sector is seen as more risky because a poor credit history suggests that person may have problems paying back future loans. A bank or building society may still lend money in these circumstances, but will charge more interest because of the risk. This makes the subprime sector more profitable, but only as long as enough borrowers manage to keep up their payments.

In recent years, rising house prices have encouraged people to take on big mortgages, believing they would make the money back when they sell their home for a profit. For a few years, this system worked. However, the subprime market is more at risk from rising interest rates, as these borrowers are already paying a lot for their loan. As interest rates begin to rise, more people are unable to keep up the payments on their mortgages and lenders begin to take possession of properties to recover the cost of the loan.

Global impact

So, how did a housing problem in the US affect the rest of the world? The crisis arose because the US mortgage lenders had passed the rights to the mortgage payments (affectively the IOUs) and related credit/default risk to third-party investors (both in America and international) via financial instruments.

These instruments called mortgage-backed securities (MBS) and collateralized debt obligations (CDO), are products which originally had a very good credit rating because of the way they were packaged. But with the downturn of the housing market and the increase in people unable to repay the loans, corporate, individual and institutional investors holding MBS or CDO faced big losses, as the value of the underlying mortgages declined.
The subprime crisis led to a reduction in economic growth, because fewer loans decrease investment by businesses and consumer spending, which is what drives the economy.

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