Vittal Lakshminarayanan Econ211 B05: Term Paper 11/02/2008 SUB-PRIME LOAN CRISIS Sub-prime loans or sub-prime lending is an economic term used to describe when banks provide credit to people who otherwise would not be eligible if the banks followed the traditional credit rating system. These borrowers carry a higher risk for the lender and the guarantee of the loans being repaid post maturity is lower due to their history of loan defaults, bankruptcy or even limited debt experience. Although the government doesn’t define a sub-prime borrower, they are usually set apart through the FICO credit rating (usually below 660). The sub-prime market covered motor vehicle loans, consumer credit cards and housing loans. The rise and fall of the sub-prime market has been told as a story of a flood of Wall Street money and the desire of Americans desperate to be part of a housing boom (Lynnley Browning, 2008, The Subprime Loan Machine, New York Times). Lenders take these risks of providing credit to people with shoddy credit scores due to the higher rate of interest expected from subprime borrowers. The ‘American Dream’ is something that is sought after by everyone in the USA. Probably the biggest and most integral part of that dream is to own a home. Owning a home is a great way to build up wealth and also a symbol in American society to indicate that one has “arrived”. But with rising home prices, many people couldn’t afford to purchase houses on their own. This is where the subprime mortgages came into play. People who otherwise couldn’t afford the prices due to a bad credit score were now able to do so with the help of banks offering loans to subprime borrowers. The catch was that the borrowers had to pay a higher rate of nominal interest. These banks also offered different options for repayment. They allowed the borrower to make interest-only payments for a period of time, which set up an illusion for the borrower. The borrower looking at the figures would think that...