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A subprime meltdown is said to occur when large numbers of mortgage borrowers who qualified for loans despite having poor credit scores end up defaulting on the debts. Aside from impacting lenders, such a meltdown also has an impact on investors because in many instances these loans are packaged and sold as debt instruments on the investment market. The homeowners who default on the debts normally lose their homes since laws in most nations enable lenders to foreclose when borrowers fail to honor their obligations to repay secured loans.
In many countries, credit rating agencies gather information pertaining to the financial strength and borrowing habits of individuals and entities. These firms use this information to create credit files and lenders can acquire copies of these reports prior to extending credit to people or companies. Typically, credit agencies assign scores to borrowers and in most instances, the people who seem most likely to repay their debts are said to have prime credit scores while people with a poor history of managing debt receive low scores that are sometimes referred to as subprime. During periods of recession, people with varying credit scores often end up defaulting on their debts but a subprime meltdown is an event that largely involves borrowers with poor credit.
Some investment firms sell bonds or mortgage-backed-securities that are tied to investment funds that contain thousands of subprime loans. The interest payments made on the underlying loans are passed onto shareholders in the form of dividend payments. People with poor credit are viewed as high-risk borrowers and consequently these individuals are required to pay above average interest rates on loans. Consequently, investors are often attracted to these securities since the yields are much greater than on more conservative investment types. During a subprime meltdown, investors stop receiving dividend payments if the majority of the underlying loans go into default and in many instances the share in the funds become ultimately worthless.
Attempting to minimize risk, some banks sell subprime loans to investment firms; however, many banks are indirectly exposed to the default risk because banks often sell credit default swaps to other firms and these swaps work similarly to insurance contracts. If the entity that the bank insures defaults on its debt obligations, then the bank that issued the swap has to make a payout to that firm's creditors. During periods of economic boom, banks generate significant amounts of income through selling swaps. When a subprime meltdown occurs, many banks lose huge amounts of money as a result of having to make payouts when other firm's that hold subprime loans run into financial trouble.
Banks that run into financial trouble have to curtail lending and this means that businesses cannot get the necessary financing to add new jobs or to expand operations. Furthermore, many firms reduce spending due to the lack of financing opportunities and this leads to job losses. A subprime meltdown, consequently, can eventually contribute to a major economic crisis.