Students and professionals related to finance very frequently hear this term subprime and I can bet not all of them are entirely familiar with this term that is believed to have caused the biggest global recession of 2008 that can be studied in detail in Lehman brothers case study.
*Here in this article, we would be briefly discussing this term to understand it better. *
Most experts opine that the great recession that almost crashed the US economy was precipitated by the bad behavior of some of the biggest wall street banks especially Lehman which was considered the fourth largest investment bank at that time.
###Subprime loans explained###
Various types of borrowers borrow money from banks for their diverse needs. To put it in simple words, we can further categorize these borrowers in different grades.
Here A is considered as the highest mark and F being the fail.
A grade borrowers
These are the borrowers who have an excellent credit history with banks with no late or deferred payments at all. Such borrowers are considered the apple of bank’s eye to which the banks literally crave to lend their money having a presumption in their mind that their loan is pretty safe and would return with a hefty interest right on time. These kind of borrowers are ranked high based on the following characteristics
- High-value assets in possession
- Sizeable bank accounts
- Stable and high paying jobs
- Great credit history with banks
- Positive customer behavior according to history
F grade borrowers
These are clearly the borrowers on the other poles of the grading system, which by default implies that these are the ones with the lowest probability of returning the loans. These types of borrowers certainly have a very poor credit history with banks with numerous late or even no payments at all. Such borrowers are never considered by any banks with a presumption of losing the whole sum of the loan altogether with the lowest probability of any paybacks. They are also categorized on basis of some certain characteristics as given below
- No assets in possession
- No stable or even any job
- No source of constant income
- Poor credit history with banks
- Negative customer behavior according to bank history.
Middle grade or subprime borrowers
The borrowers lying in the middle of the grading chart i.e. C and D are basically the ones who apply for the subprime loans. Again, these are usually the borrowers who are not as good as the A-class, nor as bad as the F ones. They are somehow somewhere in the middle again with some limited prospects of payback capacity. Although the banks loot at them pretty skeptically yet they leave room for them to apply for subprime loans. These borrowers are usually with
- Relatively low paying jobs
- Barely make ends meet
- Mostly without any formal college degree
- Residing in a low-income neighborhood
Most lenders consider these kind of borrowers a higher risk. The interest rate in their case also tends to be a bit higher around 2 % as compared to the prime borrowers having A and B grade.
###Why still banks lend money to subprime borrowers?###
Well, this is probably the biggest reason that triggered and escalated the 2008 US recession that literally brought the economy on the verge of collapse. When the same question asked from the experts, they answered that banks lend money to such subprime borrowers with an expectation that this credit support would help them elevate their financial position or they will eventually get better paying jobs and the bank will get its money back with a relatively higher interest rate.
A rational professional wouldn’t suggest it a better name than mere gambling. This is a very impractical theory and this was the very reason that cause the 2008 great recession of America. Most of these subprime borrowers are living on fixed incomes, some are retirees, while the rest buy their bread and butter through the fixed government assistance.
##Lehman Brothers a classic case of subprime borrowings and failed recoveries##
The Lehman Brothers was then the fourth largest investment bank that defaulted mainly due to the subprime lending to a large number of borrowers. When the number of loan defaulters crossed the expected and estimated limit, the investment giant was them compelled to file a default case. This 158 years old company ended in the September of 2008.
Lehman Brothers filed a chapter 11 bankruptcy protection on September 15, 2008. A company that was considered too big to fail ultimately failed. 26000 employees lost their jobs in this crisis. Soon after many other companies also followed Lehman Brothers and filed bankruptcy.
This massive bankruptcy rate of many giant companies was later coined as The Great Recession. Recession also stretched to Canada and even Europe. 9.8 million jobs were lost worldwide. 10000 committed suicide and all this happened because of a miscalculation or wrong perception. Subprime borrowers mainly caused this chaos in the world economy.
