Background Information
Mary Taggert is contemplating extending subprime loans for her bank. According to Johnson et al. (2010), her competitors have enjoyed increased profits since entering into this market. Therefore, she is exploring new lending approaches to gain a competitive advantage by growing the number of borrowers. The two percent lending premium for subprime loans attracts more customers to bank their income. Taggert also plans to assist customers limited from accessing traditional, prime home loans. She will offer financial advice and counseling to customers with low credit ratings based on late payment, liquidation, and the problem with income documentation. This discussion focuses on the case of Taggert’s bank and the lending of subprime loans to homeowners.
The Extent of Adverse Selection in the Subprime Loan Market
Mary Taggert faces two main challenges in managing the loan business for her bank. First, she has to address the issue of adverse selection before extending a loan. She is also required to offer adequate motivations to decrease the moral hazard concern. Issues of adverse selection, in this case, are the result of asymmetric information. Adverse selection pertains to hidden information in which case potential borrowers have more information regarding probable behavior and financial condition as compared to the bank (Hui et al., 2018).
The main issue Taggert faces is that she has to establish lending criteria that give the bank a competitive edge by being more lenient to its borrowers. However, the borrowers will pose a higher risk and will be less likely to maintain payments. The information they have about their behavior and financial condition is a risk to the bank, especially when it extends loans.
The Extent of Moral Hazard in the Subprime Loan Market
Moral hazard is a popular concept in the banking and insurance sectors. According to Rowell and Connelly (2012); Wen et al. (2015), it pertains to the impact of insurance on the incentives to reduce risk. Johnson et al. (2010) illustrate the concept of moral hazard using the case of Mary Taggert’s bank. For example, the authors explain that if Taggert extends the loan, she will be required to provide adequate inducements to prevent the moral hazard concern. Taggert’s opinion is that moral hazard concerns can be reduced by demanding a minimum down payment of 10% of the property’s value. In this case, the homeowner will be the first to incur a loss in the event of a decline in property value; therefore, the owner has an incentive to maintain property value.
Proposed Loan Product and Sale of a Percentage of the Loan
Many people in the United States desire to own homes as it creates community ties, promote civic pride, and provides stability. Taggert’s bank offers subprime loans. Taggert’s main frustration with her bank is that it has screening procedures that limit many potential customers from accessing subprime loans. Her bank only offers prime loans; as a result, she turns down borrowers with 640 lower credit scores (Johnson et al., 2010).
Many of her competitors enter the fewer subprime markets and are successful. Taggert wishes to offer subprime loans that require at least a 10% down payment. These proposed loans will have a fixed rate that comprises advance fines that can be imposed within the initial two years but can have an adjustable-rate mortgage after two years. The loans will provide for compensation of associated risk; therefore, borrowers will pay a 2 percent higher rate as compared to the bank’s traditional prime home mortgage loans. Johnson et al. (2010) illustrate that 10% down would protect Taggert’s bank in the event of foreclosure. The proposed changeable rate would increase the attractiveness of the loan.
The bank’s adjustable-rate mortgage is indexed comparative to the London Interbank Offer Rate and Taggert is comfortable with these rates and features. She feels that with these features, her borrowers will be able to meet their mortgage payments as well as reestablish higher credit scores (Johnson et al., 2010). With these, Taggert will be able to address her concerns regarding entering these markets. I think that the bank can exploit different avenues, such as lowering interest rates for mortgages, to attract more customers. Taggert should offer financial advice and counseling to give these customers another chance.
Therefore, Taggert should target Americans with lower credit scores by providing advice on how to raise their credit score and own homes. As a result, the bank’s customer base will eventually increase and gain a competitive edge.
Subprime loans are characterized by multiple advantages and disadvantages. For example, subprime loans have ease of approval and they are essential for individuals required to pay off other debts. They also have some disadvantages to the mortgagors; for example, they demand borrowers to have sufficient income. Borrowers of subprime loans face high risks and are more likely to default on their loans as compared to those of prime loans (Garg, 2018). Therefore, subprime loan borrowers pose higher risks to lending banks. Taggert has to consider the above pros and cons of subprime loans before making any lending decisions.
Summary
Taggert’s bank plans to extend its subprime loans and is exploring new lending methods that will increase its competitive edge. Taggert believes that the 2% lending premium for subprime loans is more attractive to Americans seeking to own homes. Therefore, the implementation of the 2% would attract more customers to bank their income with Taggert’s bank. Taggert faces two problems while managing the loan business for her bank; moral hazard problem, and adverse selection problem.
The bank’s screening approach for potential borrowers locks out many potential borrowers. However, the bank uses a strict screening process for applicants to manage the problem of adverse selection. Taggert is frustrated by the bank’s screening rule as it only allows loans to highly qualified borrowers. Addressing these problems that the bank is facing will increase its competitive edge.
References
Garg, N. (2018). Subprime lending and credit risk management in securitization. Banking & Financial Services Policy Report. 37(7), 1-21.
Hui, X., Saeedi, M., & Sundaresan, N. (2018). Adverse selection or moral hazard, an empirical study. The Journal of Industrial Economics, 66(3), 610-649.
Johnson, G., Roberts, W. W., & Trybus, E. (2010). To loan or not to loan: A subprime dilemma. Journal of the International Academy for Case Studies, 16(1), 107-114.
Rowell, D., & Connelly, L. B. (2012). A history of the term “moral hazard”. Journal of Risk and Insurance, 79(4), 1051-1075.
Wen, J., Chen, K. C., & Wu, L. (2015). An empirical study of adverse selection and moral hazard in the property and liability reinsurance market. Journal of Finance and Accountancy, 19, 1-22.