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What are Subprime Loans?

Subprime loans are loans made by institutions to individuals who do not meet the industry standards for a desirable loan client.

Lenders such as banks and mortgage companies are able to shift much of the risk of loans they make by selling the debt off to investors and investment banks in the form of collateralized mortgage obligations and other forms of securitized debt.

This paves the way for lenders to adopt more liberal guidelines around who can receive a loan for their home purchase and so forth. A thorough banker who is preserving the financial stability of his employing institution will perform due diligence to prove that a client can meet the repayment schedule for the loan by showing adequate cash flow and credit history.

A lender who is less concerned with the impact on their employing institution, and more concerned with the fact that several other lenders in town have policies even more lax than their own, is going to be more likely to help infuse the economy with debt that is a riskier asset than it may appear.

The contracts written with CMOs, for example, with impressive yields tied to a concrete, everyday asset like home mortgages, are quite enticing for individuals and institutional investors alike. This overweighting in assets which were riskier than their ratings let on was a big factor that caused the crash of 2007-2008.

Borrowers who have excellent credit history and income are able to get loans close to the Prime Rate, which borrowers with questionable finances will pay a rate above Prime.

Keywords: Mortgage-Backed Securities (MBS), 2008, cash flow, securitized, Collateralized Mortgage Obligation (CMO), prime rate, subprime loans,