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Understanding Subprime

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UBS Wealth Management Research / 19 February 2008

Education Note
Understanding Subprime
At a glance This Education Note addresses the key questions that private investors most often ask WMR about the US subprime credit crisis. Q&A Style We employ a question-and-answer format to represent a typical conversation between a private investor and a UBS WMR analyst What is subprime? The term "subprime" is applied to the lowest of three main quality categories – Prime, Alt-A and Subprime – used to classify home loans in the US mortgage market. Fig. 2 shows the relative size of each segment. The classifications are based on the size of a mortgage borrower's initial payment, or "down payment," and credit quality. Prime mortgages are for amounts that are relatively small compared to the value of the property; they are granted to a borrower who has a clean credit history and sufficient current income to meet payments. Alt-A lies between Prime and Subprime in terms of loan quality. Basically, three types of borrowers fall into this category: those who have no credit history good or bad, but who may otherwise be considered Prime; those who borrow for a house they will not themselves occupy; and those who, for whatever reason, do not disclose necessary data like the current income. Subprime borrowers have a credit quality that is too low for Prime mortgages. Reasons can include a flawed credit history or low income levels relative to the necessary mortgage payments. Why did banks lend to subprime borrowers? Subprime mortgages offered access to credit to borrowers with a weak credit record, enabling them to purchase homes, finance other forms of spending or pay down high-interest-rate consumer debt. As real estate prices continued to rise, subprime borrowers were able to roll-over their mortgages after a specified number of years by repaying the outstanding loan with funds from a new mortgage loan based on the higher valuation of the property. Thus, borrowers realized...