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.