Subprime Basics

Otay, so I've been asked by several people to explain to them what is going on with the subprime mortgages, and specifically why its affecting the market. I thought it might be useful to explain the basics. Note while I having been doing a lot of studying of finance and economics during my MBA classes, I am not an expert or an industry expert. So take everything I say with a few grains of salt...

Let us start by taking a look at what happens when Jane Q Public goes to the bank to get a loan on a house. Jane will apply for the mortgage at a local bank or mortgage broker. The banker will then look at Jane's application looking at the amount requested, the value of the home, her employment and income history, and her credit history. If her credit score is below 620, or if the requested loan is larger than normal for her income level, she will be labeled as sub-prime. This means that lending to her is considered more risky and will result in higher interest rates.

Lets fast forward a little and assume the mortgage was issued and the house was closed on. This now means that Jane has a house, monthly mortgage payments and the bank has a loan to an individual which has a higher than average possibility of defaulting on the loan. Now in the olden days the local bank would hold the loan and that would be that. However, today's investors have found that they can mitigate risk by pooling a bunch of loans together. So a company, such as Countrywide, will buy the loans from the bank from all over the country and the world and assume the risk.

This of course goes another step. The company will then pool all the like risk mortgages together and then sell a percentage of that pool to an individual investor, hedge fund, or retirement fund in the form of bonds. Effectively what is happening is that investors are funding the loans to consumer through a number of steps.

Now fast forward to today. Many of the subprime loans are being defaulted on because, surprise, the loan was high risk and the individual couldn't afford the payments, etc. Now the company that holds the loan will foreclose on the property and then resell the home to recoup the loses on the mortgage. This is expected thus the higher interest rates to help recoup the losses (remember its a numbers game). Everything should be fine because they planned for a percentage of the loans to default, right. Sort of, but now comes the rub. The value of homes has been dropping recently and more than the expected number of loans are being defaulted on. This means that the subprime market is getting hammered because they are losing more loans than expected and they recouping less from each foreclosed on house.

Many of the subprime lenders are declaring bankruptcy, meaning basically that the bond that the investor purchased is now effectively valueless. This is rippling through the markets as investors are reevaluating their portfolios and their returns.

Hope this helps. Heres a link to wikipedia that has a description of the subprime crisis http://en.wikipedia.org/wiki/Subprime_meltdown

Peace out..