The answer is quite straightforward, but maybe confusing to those who are not in the subprime finance business. In essence it boils down to a simple case of security and potential loss. If someone defaults on a personal loan, there is no real potential of recovery of any of the funds in a swift period of time.

For instance, customer A defaults on a personal loan, apart from taking them to court and trying to recover income from them, there is no alternative and if the customer has a genuine reason for default, it’s unlikely that you would obtain a judgement for anything meaningful in terms of monthly instalments. Therefore your loss is total – advance, minus payments made and the derisory judgement the court makes in a repayment schedule; assuming that the customer actually keeps to it. In this scenario, your return will drip feed in over many years and without doubt you will have to chase the customer for the payments as well. All in all, not a good position to be in if you’re a lender, this is why loans with no security are few and far between in the subprime world.

Let’s now take the subprime car loan. First of all, the lender knows that there is an asset they can repossess and sell in the event of default, so immediately were ahead of a personal loan in terms of loss. Secondly, we know that the vehicle is more than likely a critical requirement for the customer, few people want to get public transport and nowadays in general we all prefer to travel by car. This means that the customer has a reason to pay for the loan as well, so were looking good now.

Not only do we have some immediate return in the event of default, we also know there is a need for the customer to pay for the loan, rather than the basic obligation of a finance agreement. Now we now need to analyse what the loss situation is going to be. The loss is in direct proportion to the amount you lend on the vehicle relative to resale/auction value. Lending someone £10,000 on a car that’s worth £600 at an auction is dumb and is as good as writing a personal loan. Sure, cars still depreciate; however, you’re betting that the instalments made will help offset this problem.

A standard market value in the subprime sector is to lend retail value (mileage adjusted), using an agreed independent and updated valuation source (Glass Guide or CAP) in the hope you will obtain trade price at the auctions. For those not in the “know” circa 120-125% of trade represents the retail amount, however, prices do vary.
Operating in this manner, the dealership or seller makes enough profit out of the metal for it to be worth their while and the finance company “ideally” has an asset that can realise a good amount in the event of repossession and resale at auction. This will ensure that the loss isn’t total and those customers who pay will pay for those that don’t.

The only security superior to that of a vehicle, is obviously the security of a charge on the property.

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In recent years it has been easier to get a loan or credit to fund a new car or whatever else you fancied. But now it’s all changed and times are definitely harder. The change started when the number of repossession of homes in the US suddenly started to rise during autumn 2006. The effect of this has had a knock on effect across the world and sparked a global financial crisis in 2007.

The crisis came about when people in the States started to default on mortgage payments that they could no longer afford. Due to the relatively high level of prosperity banks had been lending money to people who had poor credit histories and were considered high risk. In order to minimise the risk banks, charged higher interest rates for these loans to ensure that they would get the cash back. Borrowers began realising that lenders were open to them, and were enticed by the rise in housing prices, so took out a mortgage to get on the property ladder. However in 2006-2007 housing prices in the US started to fall which has lead to a difficulty in re-financing homes for more favourable rates. People were therefore stuck with expensive mortgages that they just could not sustain over the long term.

Mortgage defaults were quickly responded to with repossessions, and people started to lose their homes. By October 2007 the rates of repossessions were three times higher than the number in the same month of 2005. By January 2008 this had risen even steeper by another 5%. During the whole of 2007 1.3 million homes in the US were repossessed, leaving the banks with a deficiency of between $200 and 300 billion dollars.

This all had a big effect on the American stock market which in turn negatively influenced economies around the world. The banks suddenly did not want to lend money any more to anyone that could be considered higher risk and heavy lending restrictions were put in place. This has transferred over to the UK where the number of house repossession in the last year has also risen. However sub-prime lender in the UK accounts for only 6% of all lending where as in the US it accounts for 20%. Despite this there have been heavy crackdowns who is eligible to be lent money.

The banks are in part to blame for this crisis, with the Financial Services Authority (FSA) taking action against 5 brokers, after their review of the mortgage market last year. In addition the FSA found out of the 34 brokers they monitored one third failed to properly assess if the consumer could actually afford the loan. Consumers were being asked to fill out self certification forms stating their income, but no further checks were made to validate these figures. Consumers wanting to borrow more money to keep up with the ever increasing prices of the house market may be tempted to inflate their earnings just to get on the ladder without thinking about the consequences.

The situation we have now been left with in the UK does look bleak. Mortgages are harder to obtain and have higher rates, however this may prompt a slowdown in house prices rising which would help more people actually be able to afford their own home.

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