Booyah Breakdown: Subprime Time

Lenders charge subprime borrowers much higher rates and fees to make up for the greater risk involved with offering subprime loans, notes Mark Grinis, a partner in Ernst & Young's Real Estate, hospitality and construction group. Subprime lending costs are higher because more applications are rejected and marketing costs are higher.

And it should come as no surprise that a higher percentage of subprime loans go into default than their prime loan brethren.

But these lenders are fully aware of the risks associated with granting subprime loans. In the past, it was assumed that about 9% to 10% of subprime borrowers would default on their loans, says Gumbinger. So the banks would reserve for those losses.

These days, however, about 13%, or 2.2 million people, in the subprime sector are in some form of delinquency. That means banks are now under-reserved.

Herein lies the problem.

The Fallout

So back to our Odd Couple episode where Felix Unger tells us that when we "assume," we make an "ass" out of "u" and "me."

We "assumed" our borrower would make his 24 consecutive mortgage payments. But he didn't, and two years later, his credit score is still in the toilet. Now he can't refinance out of his 2/28 loan and is looking at defaulting.

In this case, the lender has two options. He can either work with the delinquent borrower and create better payment terms, or he can foreclose on the guy's house. But banks are not in the business of owning homes. That's just an added expense and headache.