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The Sub-Prime Market
In the United States, extending mortgage opportunities to those not traditionally seen as being part of the
market was also part of the way in which banks and other lenders sought to increase their lending. Indi-
viduals seen as being an acceptable risk for mortgage lending were known as the prime market; the term
is said to have derived from analogy with the best cuts of meat from an animal. It followed that there was
a ‘sub-prime’ group for whom access to mortgages was altogether more difficult. Some of these people
had credit histories that were very poor, some did not have jobs, but in an atmosphere of risk seeking and
changed priorities this group provided lenders with a market opportunity.
Individuals may have been contacted in the first instance by a broker who outlined the possibilities for
the borrower often referred to as ‘affordability products’. These products sometimes included so-called
‘teaser rates’ which offered low interest rates for an initial period, often two years, and in some cases zero
interest rates for the first two years. Interest rates after the first two years could rise significantly but the
attraction for many prospective house buyers was that the chance to access mortgage funds was being
made available to them for the first time. Typical of these types of loan were 2/28 or 3/27 loans. The 2 and
3 indicated the number of years of the teaser rate and the remainder the period over which a variable rate
would apply.
Brokers would then look to sell the mortgage to a bank or other mortgage provider and received a com-
mission for doing so. Under ‘normal’ circumstances the bank would not only have acquired a liability but
also an asset (the payments received by the borrower on the mortgage). The mortgage would generate a
stream of cash flows in the form of the payment of the mortgage principal and interest over a period of
years. Such an asset could be valuable in the new deregulated banking environment and led to the secur-
itization of these assets which we covered in Chapter 26.
The growth of sub-prime mortgages began to take an increasing share of the total mortgage market in
the US and the risk involved in terms of the loan to value of property also rose from around 50 per cent
to over 80 per cent by 2005–2006. Sub-prime loans accounted for around 35 per cent or all mortgages
issued in 2004. It was not only the poor who were taking advantage of the sub-prime market, however.
Existing homeowners took advantage of the positive equity in their properties to re-mortgage or buy
second homes. Speculation in the housing market was not confined to just those in the financial markets
that could benefit from new financial instruments that could be traded for profit. Some saw opportunities
to enter the housing market, borrow funds to buy property and almost immediately put it back onto the
market – a phenomenon known as ‘flipping’. The hope was that rapidly rising house prices would mean
that the property could be sold quickly and a profit realized.
The macroeconomic background to this was a sharp cut in interest rates by the Fed in response to the
collapse of the dot.com boom and also in response to 9/11. A low interest rate environment seemed to
insulate sub-prime mortgage holders from the extent of the debt which they had taken on. From 2003
onwards, interest rates stayed at 1 per cent and for 31 consecutive months the inflation-adjusted interest
rate was effectively negative. Meanwhile the rise in house prices further contributed to economic growth
as employment in housing related business expanded to meet the growth in activity. The housing market
was responsible for creating over 788,000 jobs in the US between 2001 and 2005 – some 40 per cent of
the total increase in employment.
With the benefit of hindsight it might seem rather foolish for anyone, let alone a bank, to have contem-
plated lending money to people with bad credit histories and low incomes. Surely banks knew the risk
they were taking? Part of the answer is that they thought they did and whilst risk seeking might have been
a more dominant behavioural trait than risk aversion, strategies had been put in place to limit the risks
of the banks and other lenders to the exposure of lending to the sub-prime market. As we have seen in
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