What are 'Subprimes' and Why Does Wall Street Care?

Wall Street has a new villain. The market has been riding a volatile wave of whiplash in recent weeks and the daily blame game has been ending with the proverbial finger pointed at subprime mortgages.

But what exactly are "subprimes," what have they done wrong, and why does Wall Street care so much?

Subprime loans are mortgage loans made to consumers with bad credit ratings or insufficient collateral, who might not otherwise qualify to borrow. In exchange for the higher risk (of late payments, default or foreclosure) that lenders assume in granting such loans a) the interest rates they charge are much higher and b) other terms written into the agreement may leave borrowers vulnerable to huge payments years down the road.

In a nutshell, the consumer is paying to make up for their poor qualifications or insufficient means, and in exchange, the lender is making a riskier loan.

The trouble begins when other factors come into play that make it difficult, if not impossible, for these consumers to repay their debts. During the housing boom earlier this decade, many subprime buyers took out loans under the best of conditions — low interest rates and a booming real estate market.

Many borrowed using adjustable-rate mortgage loans (ARMs), which leave open the prospect of unpredictably higher rates in the future, but often make it easier and cheaper to borrow at the time. And many lending companies made a specialty of ARMs and other non-traditional (e.g. income only, payment option) loans that put buyers in properties that they are arguably unqualified to purchase.

The picture isn't so easy or pretty today. Interest rates are higher, and the housing market is in the midst of (some hope at the bottom of) a steep decline in both prices and sales.

Not surprisingly, subprime borrowers have struggled with the negative environment. According to the Mortgage Bankers Association, the rate of all subprime loans starting the foreclosure process at the end of last year was 2 percent, the highest in three years, while the late-payment rate jumped to 13.33 percent, the highest in four years.

So why does it have Wall Street in a tizzy? The answer may be simply that the hype has spooked investors. A 2 percent foreclosure rate in subprime loans, which make up roughly 10 percent of all mortgage loans in the U.S., shouldn't warrant handwringing on Wall Street.

Even the struggles of New Century and other lenders who specialize in subprime and other non-traditional lending aren't sufficient to prompt a correction in the stock market, according to Countrywide Financial Corp. Chief Executive Angelo Mozilo.

On Tuesday Mozilo said on a TV news program that Wall Street negativity towards lenders is an "overreaction, a baby out with the bathwater."

Nonetheless, Wall Street's decline Tuesday came as investors worried that fallout from rising loan defaults in the subprime market could hurt consumer spending, as lenders tighten credit amid the housing slowdown. Large financial firms like Citigroup (C), JPMorgan and Bank of America (BAC) were among the biggest losers of the day, due to worries over their exposure to the battered sector.

FOXNews.com's Megan Dowd and the Associated Press contributed to this report.