Subprime loans make it possible for many homeowners to qualify for a mortgage and buy a home. In 2005, subprime loans also triggered a housing bubble that we are still feeling the effects of for nearly the last decade.
Subprime loans are made to borrowers who are highest risk: either they don't have a good income history, little or no down payment, or their credit scores are bad.
The housing boom and the bursting bubble
In 2005, Wall Street investors were anxious to securitize subprime loans in hopes of a big return on their investment. This encouraged lenders to push high-risk loans. The assumption was that loans would be refinanced and the prices of homes would rise.
What happened was that eventually, home prices dropped, there were massive foreclosures and investors lost billions in the housing market. The bursting bubble was severe enough to help take down investment giants Bears Stearns and Lehman Brothers, just to name a couple.
The current subprime situation
Currently, subprime lending is a fraction of the total market. In the first nine months of 2013, about $3 billion of subprime mortgages were made compared to $625 billion made in 2005.
Tougher federal lending standards in the last couple of years means millions of Americans with poor credit scores have been unable to secure traditional mortgages. Lenders who operate in the new subprime space have an opportunity not only to help renters become buyers, but turn a big profit as well.
Lenders who offer subprime mortgages are much more careful. They require as much as 30% down to safeguard their investment. They have to hold onto their loans for a while or sell them to private equity firms until they establish a strong enough track record to offer mortgage-backed securities to investors.
Burned by the last bubble, investors are taking a pass on subprime for now. For the time being anyway, buyers who pose the biggest risk will have to rely on the Federal Housing Administration for mortgage loans until the new subprime lenders establish themselves as safe investment opportunities for investors.