Market concept of subprime loans and the risks they pose to the lender and borrower

Sub-prime lending has been around as long as man has lent to and borrowed from each other.  Historically, sub-prime lending had been relegated to shadow institutions, many operating outside of the law and banking regulation.  In the modern context of regulated bank lending, only "prime" risk borrowers could attain traditional bank loans; auto, home, personal credit, or consumer.

With the onset of consumer credit and nationalization of major retails chains in the 1950's and 1960's the Fair Isaac Corporation recognized the need for credit risk modeling and introduced their first credit scoring models which eventually evolved into the FICO scores that we all have attached to our personal risk profiles today.  The initial risk models were used almost solely to make a "yes" or "no" lending decisions.  Once a "no" determination was made, there was not another avenue for traditional credit.

In the 1970's Wall Street recognized a large market of potential clients who had incomes and means, but lacked acceptable credit profiles to warrant prime lending.  The business of securitization was born; leveraging the FICO risk models to spread the risk of sub-prime borrowers throughout a portfolio, thus dramatically minimizing the risk of loss. Suddenly banks no longer had to hold individual risk against an individual borrower, rather the risks could be pooled, then sliced so that risk of loss became almost zero. 

Initially, this was a boom for the consumer.  Suddenly millions of borrowers who had been locked out of the credit market had access to credit in exchange for a slightly higher risk premium (interest rate).  However, the banks continued to push the envelope in search of ever higher yields, opening risk pools to ever riskier borrowers.  By the late 1980's many sub-prime borrowers were being targeted solely for financial yield.  Banks were pushing loans on people who could not afford repayment and should never have received loans at all, much less risky credit instruments.  Credit cards in particular were charging "Loan Shark" rates to the low end of the credit risk pool knowing that a percentage would default, but that those who did pay would produce a profitable revenue stream to support the model.

By the 1990's sub-prime lending, fueled by the long-term decline in interest rate, had seeped into all facets of lending and securitization had masked the risks to the broader markets.

The role of leadership decision-making in the subprime financial crisis

Banking leaders became drunk on their success and blind to the systemic problems they were injecting into our financial system.  By the early 2000's a long-term rising tide in home values had blinded them to the real risk of a housing market correction and falsely encouraged them to use improper assumptions is risk modeling.

An ever more creative list of products (0 -down, pay-option ARM, NINA, and interest only) injected a level of uncontrolled risk into a booming market fueled by speculators and future homeowners desperate to secure their slice of the fantasy pie.  The assumptions loaded into the risk models were based on unsustainable trajectories in housing valuations, market growth, and consumer behavior.  The leaders in the financial world were telling each other what they wanted and needed to hear to keep the party going.  Facts were no longer important; rather sustaining the model and increasing yield were all that mattered.

As early as 2002 prominent Economists were warning of a credit bubble building, and by 2004 the warnings were being discussed at Freddie Mac and other large lending intuitions.  While the evidence was mounting, those in a position to take action double-downed instead.  Lenders such as Countrywide loosened lending standards and many banks followed suit.  Bear Sterns, Lehman Brothers, and others sought far-reaching markets for their sub-prime securities to keep the scheme afloat.  With the pending bust so clear and evident the financial leaders of the time completely ignored the facts and drove their business, the consumer, and the global economy to the brink of collapse.

The sub-prime financial crisis was a crisis in leadership and spurned directly by a lack of ethical and moral conscious by those same leaders.

Subprime loans: From a social boon to a historic bust

Sub-prime lending began as a mechanism to broaden consumer access to credit and afford the fruits of capitalism to a socio-economic class that had been previously excluded. The ethical considerations surrounding early sub-prime products were mostly altruistic and most Economists agreed that the social benefit out-weighed the stiffer terms applied to sub-prime products.

It is my personal belief that the confluence of automated credit decision making, the deregulation of banking, and the push of the consumer form inside the bank to outside the bank helped to dehumanize the borrower in the eyes of the institutions.  No longer was a borrower John A. Doe, but rather account #123456789 with a FICO score of 560.

As banks looked to broaden their profit channels the institutional leaders lost sight of the humans behind the loans they were pushing.  Where early sub-prime products allowed a family to buy their first car and have access to freedom of movement.  The later products turned many families into indentured servants to the banking system's profit machine.

Prime borrowers were no longer the most profitable source of revenue for the financial system.  They tended to be savvier and well versed in financial markets and less likely to accept marginal deals.  They rarely defaulted and produced little additional fee revenue for the financial system.  While valued for their deposits, it was the sub-prime borrower who represented the future of profit growth for the financial systems, not the historical customer base of prime borrowers.

As a result, sub-prime borrowers were targeted and systemically abused by an institution with an unfair advantage of knowledge, resources, and ever evolving set of rules.

Did we learn our lesson?

In the Fall of 2007 as the housing bubble burst and the tightly entwined financial markets began to unravel into their final collapse in the Fall of 2008 many on the sidelines cheered the downfall of the financial titans.  Mortgage Companies, Banks, Brokerages, Insurance Firms, Real Estate Brokerages, were all collapsing under the weight of their unethical business practices.

Many consumers, for years victims of these institutions, took what little retribution they could.  They defaulted en masse, refused to relinquish their homes and cars, and made the process of fiscal reconciliation more difficult than it otherwise would have been.

The Federal Government stepped in as the Lender of Last Resort and propped up lending giants Fannie and Freddie Mac, saved insures like AIG, and forced mergers of major banks like Washington Mutual and Wachovia, and ultimately oversaw the bailout of many Wall Street firms that would have otherwise been sunk by the weight of their balance sheets.

In the mad rush to save the economy we, as a society, forgot to ask the right questions and the hard questions.  Why did our institutions go unchecked by the Regulators?  Why were so few Executives held personally accountable?  Why were so many allowed to keep their ill-gotten wealth?  Where was the personal accountability of those accepting the sub-prime loans?  When the answers are painful and a broad-based lack of ethical bearing exists, those tough questions often go unasked...

In the aftermath, sweeping regulatory changes were enacted to prevent a credit contagion from spreading through the financial system again.  Sub-prime loans have been dramatically scaled back and are more reflective of a conservative credit environment that still provide access to credit cards, auto loans, and home loans, but no longer lure borrowers into permanent credit traps.  The financial system is reaping record profits and the same leaders who oversaw the largest financial collapse in history are still bringing home eight-figure paychecks.

So, did we learn our lesson?  Probably not.  The government took some token steps to real in the excess and there were public apologies made by many, but the deep-rooted unethical bias of our financial system survived.  Money has long been the grand corrupter of man, and that has not changed.