What it means
The market has two sides. On the primary side, lenders make loans to higher-risk borrowers at higher rates, and on the secondary side, those loans are sold to investors or bundled into securities that pay out of the loan repayments.
Investors buy these securities for the higher yield, and lenders sell loans to free up cash to lend again. This cycle can widen access to credit, but it can also encourage lenders to relax their standards if they expect to pass the risk on to someone else.
The market is sensitive to the economy, and borrowers who rely on refinancing are hit hardest when new loans dry up. When unemployment rises or house prices fall, more subprime borrowers miss payments, and delinquency (the share of loans overdue) climbs faster than in the prime market.
Investors then demand higher yields, lenders tighten standards and credit becomes harder to obtain. The wider risks became clear in the financial crisis of 2007 and 2008, when widespread losses on subprime mortgages and the securities built on them spread through banks and markets around the world.
Since then, regulators in many countries have introduced stronger rules on checking a borrower's ability to repay and on how much risk lenders must keep. Pricing in this market follows the same logic as in any credit market: yields rise when investors fear losses and fall when they feel safe.
The difference between the yield on securities backed by weaker borrowers and those backed by strong borrowers is a widely watched sign of how nervous the market is. For business readers, the subprime market is a useful gauge of credit conditions.
Rising delinquencies and tightening standards often appear there first, and they can warn of slower consumer spending and tougher borrowing for everyone else.
In practice
Real-world examples.
Example
A bank bundles $500,000,000 of car loans to weaker borrowers into securities and sells them to pension funds. Investors receive a higher yield than on prime loans, but they accept the risk of more defaults. The bank keeps a small slice of the risk itself so that it has a stake in the quality of the loans.
Example
A retailer that offers store credit to customers with weaker credit notices that overdue accounts are rising. The finance team tightens approval rules and raises its provision for bad debts. It also reports the change to the board so that the effect on profit is understood early.
Example
An economist tracks overdue payments on subprime mortgages across a region as an early signal of household stress. A sudden rise leads her to lower her forecast for local consumer spending. She shares the finding with local retailers who rely on household credit.
Formula
Calculation
A basic health measure of the market is the delinquency rate:
Delinquency rate = Delinquent loans / Total loans
Suppose a pool of subprime car loans contains 50,000 loans, of which 4,000 are more than 30 days overdue. The delinquency rate is 4,000 / 50,000 = 8%. If the average balance is $15,000, the overdue balances total 4,000 x $15,000 = $60,000,000 out of a pool of 50,000 x $15,000 = $750,000,000, which again gives 8%.Case study
Seen in the real world.
Riverbend Capital is an illustrative, fictional investment firm that bought a package of securities backed by subprime mortgages in a rising property market. The securities paid 3% more than safer bonds, and the firm treated the extra yield as a reward for a modest risk.
When house prices stopped rising, borrowers who had counted on refinancing could not do so, and delinquencies in the pool rose from 6% to 18%. The securities fell sharply in value and the firm had to sell other holdings to meet its own obligations. Prices for similar securities fell too, so there were few buyers at any reasonable price.
In this illustrative story, the firm's review found that it had relied on a rating without testing what would happen if prices fell. It now runs a stress test, which checks how the portfolio performs in a harsh scenario, before buying anything backed by weaker borrowers.
Watch out
Common mistakes.
- Assuming the subprime market is only about mortgages, when it also covers car loans, cards and personal loans.
- Treating a high credit rating on a security as proof that the loans behind it are safe.
- Believing that spreading risk by packaging loans removes it, when the losses are simply shared among investors.
Questions
People also ask.
Why is the subprime market called risky?
Borrowers are more likely to miss payments, and losses rise quickly in a downturn.
Does the subprime market still exist?
Yes, lending to weaker borrowers continues in many forms, though regulation and lending standards differ from earlier periods.
Why should a non-finance manager care?
Trouble in this market can signal weaker consumer spending, tighter credit and higher funding costs across the economy, all of which affect sales forecasts and borrowing plans.
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