What Is Sub-Prime Lending

With Australian financial markets taking a beating and Australian’s having to cope with yet another rate rise (and the possibility of another soon to follow) one word in particular is being bandied about: sub-prime. What is sub-prime lending and why – out of the blue – is it having such a profound impact on so many ordinary Australians?

What Is Sub-Prime Lending?

Sub-prime lending (also called “second-chance” lending) is the practice of lending funds to borrowers who might not otherwise qualify for a loan, whose credit rating is bad or financial situation unclear. These borrowers are considered to be a higher risk than others and so, sub-prime loans (and credit cards) have higher interest rates.

In mid-August 2007 the United States markets became aware of an increasing rate of default in the sub-prime loan category as their economy tightens. This prompted a response from the US stock market. The big question, however, is why has this had such a big impact in Australia. Following the American lead, the Australian stock market has also been battered. This situation is called “financial contagion”. Financial contagion is when the asset values in one country negatively impact the economy of another country (and can affect the availability of credit in the other country).

The Good And Bad Of Globalisation

Observers tend to take one of two positions: it’s a side effect of a global economy. A global economy has benefits but also negatives and you have to take the good with the bad. The alternative view is that financial contagion is a type of economic imperialism. Economic imperialism* being a way of applying economics to aspects of life that were previously beyond its sphere of influence eg. marriage, the approach to warfare, the management of crime, the structure of the workplace. In simpler terms,  economic impacts from one country force a shift in thinking in another country that goes beyond the realm of finance.

The Impact Of Sub-Prime Lending

Conspiracy theories aside, with a lot of unhappy investors around, it’s not surprising that fingers are being pointed at US lenders for pursuing financially vulnerable borrowers in the first place. Is it greedy and irresponsible? Has it put the savings and investments of millions of people (worldwide) into jeopardy, or wiped them out? Should sub-prime lending be banned, or should lenders be penalized by Governments (who may have to carry the social welfare costs)?

Whatever the powers that be decide it could be time to consider fixing that mortgage and getting your credit card debt under control. Australians may have some tougher times ahead.

To find out exactly how sub-prime lending caused the GFC, see our blog post "How Did The GFC Happen?"

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