Basically, subprime mortgages are those mortgages issued out to consumers having less qualifying requirements. This includes those consumers who have bad credit and are not able to secure mortgages on the prime market. Compared to prime mortgages, subprime mortgages charge higher interest rates with the bulk of them being Adjustable Rate Mortgages (ARMs) which allow the lender review interest rates from time to time based on the prime rate.
In a bid to increase credit available for consumer lending, the securitization of financial assets for which there is no secondary market gathered pace in the mid-1990s. From this, mortgage backed securities (MBS) consisting of large pools of mortgages upwards of 1,000 individual mortgages were combined and sold to investors. This practice became favorable to banks as it made more funds available without having to recapitalize while debt and risk initially tied to the bank shifts over to the investor.
From an investors’ point of view, the potential of earning sizeable profits was encouraging and considered by big-money investors like pension companies, and hedge funds as a viable investment opportunity.