Subprime debts are loans that do not conform to the criteria for “prime” or “conforming” debts, and thus are expected to have a lower probability of full repayment. This assessment is usually made based on the borrower’s credit history and score, debt service-to-income (DTI) ratio, and/or loan-to-value (LTV) ratio. In the United States (US), borrowers with low credit scores, DTIs above 55 percent, and/or LTV ratio over 85 percent are likely to be considered subprime, reflecting the greater difficulty subprime borrowers have in making down-payments and the propensity of these borrowers to extract equity during refinancing. “Alt-A” loans fall into a gray area between prime and subprime debts. These started as a more flexible alternative to prime loans, mainly for borrowers who met all the credit score, DTI and LTV prime criteria, but did not provide full income documentation (Kiff and Mills, 2007).
The growth in subprime lending represents a natural evolution of credit markets. The 1980 Depository Institutions Deregulatory and Monetary Control Act eliminated interest rate caps imposed by states, allowing lenders to charge higher interest rates to borrowers who pose elevated credit risk, including those with weaker or less certain credit histories. This change encouraged the use and further development of credit scoring and other technologies to better evaluate risk and enabled lenders to price higher-risk borrowers. Evidently, automated underwriting (using computer models rather than credit officers) has made loan origination more cost efficient while advances in statistical credit scoring have led to more accurate and consistent assessments of borrower’s credit risk.
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...on-conforming loans in Australia is also lower than that of subprime debts in the U.S. All of the above points reflect differences in the features of non-conforming loans in Australia in comparison with subprime loans in the U.S.:
• Australian non-conforming debts are less risky than its equivalents in the U.S. On average, newly approved non-conforming loans only has LTV ratio of about 75 percent, well below the average LTV ratio of 85 percent on US subprime loans.
• Lenders usually hold the lowest-rated tranches of their residential mortgage-backed securities or place them with closely associated entities, opposed to the U.S. institutions selling them to high-yield chaser such as hedge funds.
• Australian legal system gives the lender recourse to all of the borrower’s assets, not only the house, providing the borrower with a stronger incentive to repay their loans.
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