Subprime loans are typically categorized by a borrower’s weak credit score. While there is no specific definition or specific criteria that establishes a subprime borrower, the most common characteristic is a credit score below 600. These loans certainly carry a greater risk of default and thus carry a much higher interest rate. Because of this higher interest rate, banks see them as very attractive.
A Look Inside Subprime Loans
Normally, banks loan money from customer deposits (with a current interest rate of less 1.00%) or from money borrowed from the Federal Reserve. The Federal Reserve typically loans money to banks at 300 basis points below Wall Street Journal Prime (WSJP). For example, if WSJP is 4.75% (as it is today), the Federal Reserve would loan money to banks at 1.75%. Under this typical situation, a bank’s interest rate spread would be at least 3.00% or 300 basis points for a “Prime” loan. Applying this scenario to subprime lending and it is easy to see why banks of all sizes like making subprime loans.
The average interest rate for subprime car loans in 2017 was 10.98% for a new car and 16.27% for a used car. But, even though the interest rate charged to the borrower is 3 to 5 times higher than a Prime loan, the interest rate on the money the banks borrow from the Federal Reserve is still 1.75%. Therefore this was attractive to banks because, even though the risk of default is much, much higher in the long-run, most banks are lured into these loans because the short-term income potential is so great.
Does This Strategy Still Exist Today?
So, flashback to 2007 and it’s easy to see why all of the major US banks were so heavily involved in subprime loans. However, after the Great Recession of 2008, these same major banks completely exited the subprime lending market. Or, so they would have you believe. The lure of large, short-term profits will always override a bank’s long-term risk. Today, it is hard to imagine that Wells Fargo or J.P. Morgan Chase would go anywhere near a subprime auto loan…..directly. Instead, the same major banks that helped cause the greatest recession/depression since the Great Recession have found ways to “secretly” profit from subprime loans without having to disclose the long-term risk associated with subprime loans.
Enter the world of subprime nonbank direct lenders such as Exeter Finance, LLC.
In Part 2, we’ll see how the same banks that helped cause the economic devastation in 2008 are again helping to create the next Great Recession driven by secret sub-prime loans.