Turbulence in the sub-prime lending market forced several big name lenders to shut their doors to business in recent weeks.
In a healthy sub-prime environment, institutional investors buy mortgages in large bundles called “pools” from sub-prime lenders.
The current environment is not healthy, however. Loans are defaulting more quickly than in the past and investors are requiring that the sub-prime lenders “buy back” the bad loans instead of including them in the loan pools.
Unlike a traditional bank, sub-prime lenders don’t typically have a deposit base from which to make loans; the lenders often use a bank-issued credit line which carries an interest charge for every dollar used.
As a result, the bad loans sit on the books while the lender is forced to pay interest on them. To add an additional challenge — just like you and I have limits on our credit lines, so do sub-prime lenders.
So, with enough bad loans hanging around, the lender may be paying interest on the loans nobody wants and may be maxed out on their credit line. This can generate a tremendous loss for the lender who may have no choice but to sell the bad loans for cents on the dollar and/or exit the business altogether.
This is a simplification, of course, but if the default trend continues, more sub-prime lenders will find themselves in a similar pinch in the coming months.
