Subprime Lending, Its Adverse Effects on the UK Financial Market And Methods to Protect Consumers - Research Proposal Example

Research Proposal Subprime Lending, its Adverse Effects on UK and World Financial Markets And Methods to Rectify and Protect Consumers Introduction The increase of subprime lending globally is a phenomenon that presents a trend for continuous expansion. The above issue is highlighted by Rose (2007, 1) who states that ‘a recent dramatic rise in subprime foreclosures has led to calls for restrictions against a range of loan features loosely termed ‘predatory’’. In fact, lending under the particular terms (i.e. subprime lending) can have many forms around the world in accordance with the financial structure of each particular market and the rules used for the regulation of financial transactions in each state. From a different point of view, it is noticed by Reiss (2005) that ‘predatory lending, the origination of loans with abusive terms to homeowners, is rampant in the subprime mortgage market’. The approach used by Reiss in order to explain the conditions related with subprime lending is based on the extensive use of this type of lending specifically in mortgages. However, it would be necessary to notice that subprime lending is not used by all consumers worldwide; it is rather preferred by specific categories of population: those who have a high credit risk and the use for an alternative method of financing the purchase of a specific product/ asset would be proved inappropriate. In fact, it has been found by Wachter et al. (2007) that ‘subprime lending serves those with relatively high credit risk and therefore entails higher borrowing costs; this market has grown tremendously over the past decade, although with substantial variation in growth rates across the central cities of metropolitan areas in the US’. The above phenomenon does not characterize only the American financial market. In UK also subprime lending is extremely developed helping consumers to proceed to the purchase of house when such an option is not available to them (due to their credit rank). In fact, in the research made by Munro (2005, 7) it was proved that in 1995 in Britain ‘the average debt was less than £1,000 and the top ten percent of debtors owed £5,000; in 2000 the comparable figures were over £2,000 and £9,000 respectively; in mid-2002 10 per cent of family households paid more than 25 per cent of their gross income on consumer credit repayments’. In other words, in UK all the necessary requirements exist in order for the subprime lending to flourish. At this point, it would be important to define the terms under which this type of lending should be used by consumers in UK but also worldwide. The above suggestion is supported by the fact that globally the trends for personal lending present a constant increase while ‘personal lending is characterized by continuous risk-based pricing in which lenders offer households a continuous distribution of borrowing possibilities based on estimates of their creditworthiness’ (Nichols et al., 2005, 197). However, because the terms of personal lending are set by the state we should notice that there could be no case for failures in the financial markets (regarding the control of debt) if the relevant rules were precisely applied. The problem in the case of subprime lending is the fact that because of its structure, the control over its procedures cannot be close and accurate. On the other hand, it is noticed by Nichols et al. (2005, 197) that ‘the contrast between continuous lending for personal loans and discrete lending by specialized lenders for mortgage credit has led to concerns regarding the efficiency and equity of mortgage lending’. The development of subprime lending within modern financial markets depends on the their structure; in the case of UK there are options of lending that could be characterized as belonging in the particular type of lending. However, because of the continuous control of this market (in fact its control is easier compared to the one of the USA market which is quite extensive and difficult to be monitored and regulated) its development is still limited to specific categories and products. 2. Research Hypothesis The hypothesis used as a basis for the particular project would be the following one: Subprime lending is a type of lending used extensively in markets around the world; in the case of UK subprime lending is also developed however there are mechanisms that can protect consumers from severe losses. 3. Research questions and objectives In accordance with the issues developed above, the research questions could be stated as follows: a) which is the level of use of subprime lending by consumers in UK? b) are there specific forms of subprime lending developed within the British financial market; c) which options are available to consumers in UK instead of subprime lending; d) which are the advantages and disadvantages of subprime lending (use of interviews)? and e) are there any suggested improvements to current regulations related with debt in UK (these improvements should result to the limitation of subprime lending in the country). 3. Literature Review The development of lending since the decade of 1990s has caused severe financial losses to people around the world. In the specific framework, the appearance and the expansion of subprime lending should be regarded as an expected outcome. In accordance with Immergluck (2005, 362) ‘one reason for concern about this trend is that it has been associated with a large and simultaneous rise in foreclosures, which can entail significant costs not just for those directly affected but also for surrounding neighbourhoods and larger communities; subprime lending appears to account for a substantial share of foreclosure activity in high-foreclosure neighborhoods’. In fact, subprime lending is proved to affect all parts of personal and social activities through the participation of a specific person in an arrangement that is rather difficult to be handled. From another point of view, Adams et al. (2007) noticed that ‘default rates rise significantly with loan size, providing a rationale for lenders to impose loan caps because of moral hazard while borrowers at the highest risk of default demand the largest loans, but the degree of adverse selection is mitigated substantially by effective risk-based pricing’. All the above effects do not refer specifically on subprime lending but they are related with all funding arrangements especially those referring to the purchase of house. Referring to the legal framework related with the regulation of subprime lending Ho et al. (2006) notice that ‘the typical local predatory lending law tends to reduce rejections, while having little impact on the flow (application and origination) of credit; however, the strength of the law, measured by the extent of market coverage and the extent of prohibitions, can have strong impacts on both the flow of credit and rejections’. One of the main characteristics of subprime lending is the use of different interest rates than the ones applied in traditional debt arrangements. In this context, it is noticed by Heitfiled et al. (2004, 457) that ‘there are significant differences in the default and prepayment rates faced by different subprime lenders; those lenders that charge the highest interest rates experience the highest default rates, but also experience somewhat lower prepayment rates’. On the other hand, because borrowers in the specific financial arrangements do not have the necessary power (because of their need for the specific funding) the terms related with the interest rates and the prepayment options applicable in these types of lending are formulated with no particular control. In fact, subprime lending is by its nature difficult to be monitored and controlled. Of course, ‘the sub-prime sector provides opportunities for individuals and households who find it difficult to access the ‘prime’ sector and hence supports the current policy objective of widening home ownership in a context of considerable risk’ (Munro, 2005, 2) however it would be necessary that the appropriate framework is developed in order to offer to consumers around the world sufficient and effective protection by financial arrangements that will be based on extensive responsibilities by the borrower’s side. 4. Research Methodology 4.1 Instruments used for the collection of data The research on the issue under examination should be formulated in a particular framework given the fact that information on subprime lending is extremely difficult to be retrieved (the borrowers hardly provide – because of their financial condition – relevant information that would help towards the development of the current study). Under these terms, the most appropriate method for the retrieval of information on the specific issue would be the interviewing of people that work in the financial sector and deal with the specific type of financing. In any case, the literature will be extensively searched and analyzed. At a next level, the findings of the interviews could be combined with the views of the literature in order to formulate a valid assumption on the development of subprime lending within the modern UK market. As for the participants, these will be financial analysts working in some of the most powerful financial institutions in Britain. A sample of experts from about 10 British firms could be ‘engaged’ in the relevant project. 5. Conclusion - ethical considerations The examination of the terms and the conditions related with subprime lending are quite important in order to decide on the appropriate schemes of action that could be used by regulators and consumers around the world in order for this phenomenon to be limited. However, it seems that this type of lending (and lending in general) has already a strong presence within the daily life of people in Britain (as also internationally). In a research made by O’Loughlin et al. in 2006 among students of schools/ institutes of high education both in Ireland and UK it was revealed that ‘while the UK and Irish student contexts are significantly different in terms of accommodation costs, tuition fees and living expenses, many Irish students reported relatively high debt levels, with some exceeding their UK counterparts’ (O’Loughlin et al., 2006, 335). In fact, all students were found to be supportive towards lending in order to realize specific personal targets. However, in any case, subprime lending leads to severe consequences (usually severe losses) for the people involved. The above view is also supported by Capozza et al. (2005, 115) who referring generally to mortgage lending stated that ‘lender losses on mortgage loans arise from a two-stage process; in the first stage, the borrower stops making payments if and when default is optimal; the second stage is a lengthy and costly period during which the lender employs legal remedies to obtain possession and execute a sale of the collateral’. On the other hand, the existence of subprime lending is considered as valuable regarding specific categories of population. Indeed, it is supported by Chinloy et al. (2005, 153) that ‘without a subprime market, some borrowers by virtue of poor credit history, unstable income, and other characteristics are unable to qualify for a mortgage; with a subprime market, there is a more complete credit supply schedule with the market pricing for poorer credit quality in the mortgage rate’. It could be noticed here that despite the fact that subprime lending is valuable for a specific part of consumers around the world, its expansion should be controlled as it could lead to the adverse result: extremely severe financial losses within a short term period. In this context, it is suggested by Heitfield et al. (2004, 457) that ‘there is substantial heterogeneity among subprime borrowers, and that different lenders target different segments of the subprime market; because of their higher default rates, loans that carry the highest interest rates do not appear to yield the highest expected returns’. Under these terms, it should be preferable for consumers to avoid proceeding to a specific purchase instead to get ‘engaged’ to the particular financial arrangement. References Adams, William, Einav, Liran and Levin, Jonathan D., "Liquidity Constraints and Imperfect Information in Subprime Lending" (April 2007). NBER Working Paper No. W13067 Available at SSRN: http://ssrn.com/abstract=986917 Capozza, D., Thomson, T. (2005) Optimal Stopping and Losses on Subprime Mortgages. The Journal of Real Estate Finance and Economics, 30(2): 115-131 Chinloy, P., Macdonald, N. (2005) Subprime lenders and mortgate market completion. The Journal of Real Estate Finance and Economics, 30(2): 153-165 Heitfield, E., Sabarwal, T. (2004) What Drives Default and Prepayment on Subprime Auto Loans? The Journal of Real Estate Finance and Economics, 29(4): 457-477 Ho, Giang and Pennington-Cross, Anthony N., "The Impact of Local Predatory Lending Laws on the Flow of Subprime Credit" (February 2006). FRB of St. Louis Working Paper No. 2006-009A Available at SSRN: http://ssrn.com/abstract=885514 Immegluck, D., Smith, G. (2005) Measuring the Effect of Subprime Lending on Neighborhood Foreclosures Munro, M. (2005) Need a loan for any purpose? Sub prime secured lending in the UK, [online], available at http://borg.hi.is/enhr2005iceland/ppr/Munro.pdf O’Loughlin, D., Szmigin, I. (2006) I’ll always be in debt? Irish and UK student behaviour in a credit led environment. Journal of Consumer Marketing, 23(6): 335-343 Reiss, David J., "Subprime Standardization: How Rating Agencies Allow Predatory Lending to Flourish in the Secondary Mortgage Market" (September 2, 2005). Florida State University Law Review, Vol. 33, 2006 Available at SSRN: http://ssrn.com/abstract=797164 Rose, M. (2007) Predatory lending practices and subprime foreclosures: Distinguishing impacts by loan category. Journal of Economics and Business, [online], available at http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B6V7T-4PW05BH-1&_user=10&_rdoc=1&_fmt=&_orig=search&_sort=d&view=c&_acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=5a9e36e911f85c8a0f35b1e22b0fb93b Wachter, Susan M., Russo, Karl and Hershaff, Jonathan E., "Subprime Lending: Neighborhood Patterns Over Time in US Cities" . U of Penn, Inst for Law & Econ Research Paper No. 06-19 Available at SSRN: http://ssrn.com/abstract=920847 Read More