Subprime Lender: What it Means, How it Works, Example

What Is a Subprime Lender?

A subprime lender is a credit provider that specializes in borrowers with low or "subprime" credit ratings. Because these borrowers represent a higher risk of default, subprime loans are associated with relatively high rates of interest.

Subprime lending became a topic of considerable interest in the wake of the 2007–2008 financial crisis, where it was widely viewed as contributing to the sharp decline in the U.S. housing market.

Understanding Subprime Lending

Subprime lenders are creditors who offer loans to individuals who do not qualify for loans by traditional lenders. By definition, these subprime borrowers have below-average credit ratings and are therefore presumed to be at greater risk of defaulting on their loans. To mitigate against this risk, subprime lenders use risk-based pricing systems to calculate the terms and interest rates of their subprime loans. Because of the added risk of subprime borrowers, subprime loans invariably carry relatively high interest rates.

Traditionally, the relationship between a subprime lender and a subprime borrower would be relatively straightforward. The lender would accept the risk that the borrower might default on their loan, in exchange for an interest rate paid by the borrower. The lender would profit if, on average, the interest earned on the subprime loans were sufficiently in excess of the principal lost to default. Oftentimes, subprime lenders would ensure that they have a large and diversified portfolio of subprime loans in order to manage their default risk.

In more recent times, however, this relationship between lenders and borrowers has become significantly more complex. This is due to the phenomenon of securitization, whereby lenders sell their loans to third parties who then package those loans into distinct securities. These securities are then sold to investors who may be entirely unrelated to the initial lender or the party responsible for packaging the loans.

Because of securitization, it is possible for subprime lenders to effectively rid themselves of the default risk associated with their subprime loans. By selling those loans to investors through the process of securitization, a subprime lender can now focus solely on initiating new subprime loans and then selling them off quickly to a securitization provider. In this manner, the risk of default is transferred from the subprime lender through to the investors who will eventually own the subprime loan by way of the securitized product.

Real World Example of Subprime Lending

This combination of subprime lending and securitization is generally viewed as having contributed significantly to the 2007–2008 financial crisis. In the years before the crisis, subprime mortgage lenders sold large quantities of subprime mortgages to securitization partners who used them to produce securitized products known as mortgage-backed securities (MBS). These securities were then sold to various investors throughout the world. 

One criticism of this practice is that it removed the incentive for the subprime mortgage lenders to ensure that the default risk of their loans remained within a manageable level; because the risk of default was transferred to the MBS holders, the subprime lenders were incentivized to produce as many subprime loans as possible, irrespective of their default risk. This led to a steady deterioration of mortgage standards, until the average quality of mortgage loans declined to a dangerous and unsustainable level.