The subprime mortgage market consists of loans to borrowers with high credit risk, and the mechanisms that have evolved to originate, service, and finance those loans. While this market has existed since the early 1980s, it was not until the mid-1990s that the growth of the subprime industry gained significant momentum. A decade ago, five percent of mortgage loan originations were subprime; by 2005 the figure had jumped to approximately 20 percent. Currently, there are about $1.3 trillion in subprime loans outstanding, with over $600 billion in new subprime loans originated in 2006 alone. Figure 1 shows the growth of subprime originations over time.

Several factors contributed to the fast growth of the subprime market. Most importantly, there has been an increase in the rate of securitization. That is, many more mortgages are now repackaged as mortgage-backed securities (MBS) and sold to investors. Also, there have been various credit innovations and a proliferating range of mortgage products available to the subprime borrower. These factors increased liquidity, reduced costs of lending, and enabled a greater number of previously unqualified borrowers to obtain loans. As of 2006, over 60 percent of all loans not eligible for prime rates were securitized.

Several structural and economic factors have recently slowed subprime growth and increased delinquencies and foreclosures. Some of these factors include the rise in short-term interest rates and the decrease in the rate of home price appreciation (with actual price declines taking place in many locations). As a result of mounting defaults and delinquencies, one of the largest subprime lenders, New Century Financial Corporation, filed for bankruptcy on April 2, 2007. With the industry rapidly contracting, many other lenders have since followed suit, or simply exited the subprime market altogether. Consequently, many lenders, borrowers, and investors have filed lawsuits.

While the subprime mortgage business is the focus of this primer, it is worth noting that this “meltdown” (as coined by the news media)6 is affecting all areas of subprime business, including automobile loans and credit card lending.

In this primer, we provide a brief description of the subprime mortgage industry and the process of securitization; we examine the economic factors leading to the deterioration of the US subprime mortgage industry; we identify some of the factors that differ between the current crisis and the 1998 crisis; and we discuss pending and potential litigation issues arising from the current industry difficulties.

Visit The Subprime Meltdown: A Primer Website

You can download the working paper in pdf format.

Forthcoming topics in this subprime lending series will include:

• Finance & Accounting Aspects of a Securitization
• Anatomy of a Fraudulent Conveyance
• De-Mystifying the Economics of Complex Mortgage Transactions
• The Domino Effect: Economic Impact of When Exotic Mortgages Reset

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