What Is Subprime? An easy explanation

 

SUBPRIME

Have you heard about subprime crisis in U.S? Do you know what is it? Do you know why it happens? This article provides a very simple explanation of subprime crisis especially for those non-financial people or economist.

It was a very hot issue that has been discussed over the last year. I tried to search around the web to get more information about this subprime crisis in U.S. but all those explanations were too difficult for me to understand. So, this article is to simplify the explanation of subprime crisis which appears to be a very complex thing. I did this on my own research based on my understanding. You can verify whether my understanding is correct or not.

What is Subprime Mortgage?

First of all, we need to understand what subprime means. By dictionary, "Subprime" is an adjective relating to or for people with a poor credit rating. Simply says, if you never clear your credit card balance monthly, you have a poor credit rating. A poor credit rating people are disqualified to apply for conventional mortgage or loan application. They're disqualified because they have higher risks that they are not able to make the loan payment due to their poor credit history. Bank is very clever. They come out a special type of loan to these poor credit rating people. This loan or mortgage is called "Subprime Mortgage" or "Subprime Loan".

Therefore subprime is a classification of borrowers with a tarnished or limited credit history. Lenders will use a credit scoring system to determine which loans a borrower may qualify for. Subprime loans carry more credit risk, and as such, will carry higher interest rates as well. Approximately 25% of mortgage originations are classified as subprime.

Occasionally some borrowers might be classified as subprime despite having a good credit history. The reason for this is because the borrowers has elected to not provide verification of income or assets in the loan application process.

Why Banks Want Subprime Mortgage?

Why banks (subprime lenders) want to lend money to those who have bad credit history? They may not even able to payback the bank. But still, why they want to do that? Yes, you got it. It is all related to money. The banks are also greedy and they want to earn more. The main reason why the banks want to do this is they predict the value of the property will be going up. So they increase the mortgage interest rate (higher than the conventional loan) and they call it a subprime mortgage. They earn more with the higher mortgage interest rate and just in case the borrowers can't continue the payment, they still can sell the houses with higher value due to the property appreciation.

To further reduce the risks and to get more loans (earn more money by loan interest), the banks repackage all mortgages into an investment product and sell it to financial institutions in all over the world (not just in U.S). This is now not only between banks and borrowers get involved in this subprime mortgage but also all the financial institutions around the world. You may ask why they want to invest in this high risk product (pool of subprime mortgage)? One reason, they believe that the property value will go up.

What happen to subprime borrowers?

They buy the house only for one reason which is expecting value of the houses to go up and they earn from the property appreciation. They can rent out their house with higher value or they can sell the house with higher value. All the debts they had previously can be easily paid off. Because house prices had increased so rapidly in the past few years, paying back the loan payment is not a problem at all. The borrowers also refinance their loan at more favourable terms due to they no longer have a bad credit rating history.

Can you see that? Everybody wins! Borrowers, banks and financial institutions are eating the same cheese happily and the cheese is "property appreciation". Yummy, yummy!

 

When and Why Crisis Happens?

I think you should be able to guess it by now when the crisis will happen. Everybody enjoys the same cheese, if the cheese is gone, what happen? Crisis happens. It is that simple. When the house or property values drops, the cheese is gone. Everybody wins now becomes everybody loses!

When demand is more than supply (everyone wants to buy house), the property values went up like crazy. Until one day, when it becomes much more expensive to borrow, less people could afford to buy a house. As there were not as many buyers, the real estate market begin to cool down and house prices begin to fall.

When the house prices begin to fall, the subprime borrowers are going to suffer. Not only they're not able to pay their existing debt, they are stuck having to pay a much larger mortgage payment. This causes many of these borrowers to not be able to make their house payment.

So for the financial institutions, they are going to lose their money that they invested because the borrower are not able to pay the loan payment. On the other hand, banks have a very big problem also because they rely on this these financial institutions to invest in the pool of mortgages investment product. Financial institutions no longer wants to invest and do not trust the bank anymore. If no wants want to buy them, where the banks get the money to offer the loans?

They bank also suffer from the lost for those borrowers who failed to make payment. As a result, the banks increase the mortgage interest rate to cover loses and hopes that borrowers (who afford to pay) can pay more. Sadly, the effect is opposite and this even makes the conditions worst. More and more borrowers failed to pay their monthly loan payment due to the interest rate increases. Crisis happens! Everyone suffers!

Going a bit more deep into the subject. A financial crisis that arose in the mortgage market after a sharp increase in mortgage foreclosures, mainly subprime, collapsed numerous mortgage lenders and hedge funds.

 

The meltdown spilled over into the global credit market as risk premiums increased rapidly and capital liquidity was reduced. The sharp increase in foreclosures and the problems in the subprime mortgage market were largely blamed on loose lending practices, low interest rates, a housing bubble and excessive risk taking by lenders and investors.

It is also known as the "subprime collapse" or "subprime crisis".

Following the tech bubble and the events of September 11, the Federal Reserve stimulated a struggling economy by cutting interest rates to historically low levels. As a result, a housing bull market was created. People with poor credit got in on the action when mortgage lenders created non-traditional mortgages: interest-only loans, payment-option ARMs and mortgages with extended amortization periods. Eventually, interest rates climbed back up and many subprime borrowers defaulted when their mortgages were reset to much higher monthly payments. This left mortgage lenders with property that was worth less than the loan value due to a weakening housing market. Defaults increased; the problem snowballed, and several lenders went bankrupt.

Investors and hedge funds also suffered because lenders sold mortgages they originated into the secondary market. Here the mortgages were bundled together and sold to investors as collateralized debt obligations (CDOs) and other mortgage-backed securities (MBSs). When the higher risk underlying mortgages started to default, investors were left with properties that were quickly losing value. In the wake of the meltdown, central banks released liquidity into the market place, which allowed struggling lenders and hedge funds to continue operations and make the necessary payments on their obligations.

Conclusion

Subprime crisis happens because everyone predicts the property value will appreciate over time. The economy now is no longer as simple as in 30 years ago where we can predict the future with certain of accuracy. Future is getting harder and harder to be predicted for the coming years. What it next? It is really unknown.

Therefore the impact of this crisis is still has a lot of uncertainty. Will it cause another economy recession in U.S since 2000? Will this affect other countries? This is another huge topic to be discussed. Anyway, I hope this post is making sense and give you a little bit general idea on this subprime mortgage crisis in U.S.

 

 

 

7 Days that shocked the Wall Street

7 Days that shocked the Wall Street

It was the week that shook the financial world to the core. On Friday, Sept. 12, traders left the New York Stock Exchange for the weekend. But key banking officials, facing the impending failure of the venerable Lehman Brothers investment house and a shaky outlook for two other huge financial players—investment firm Merrill Lynch (MER) and insurance giant American International Group (AIG)—began a series of weekend meetings in an effort to prevent a possible collapse of the global financial system.

Over the next seven days, the nation's financial leaders, captained by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, produced a rapid succession of moves that reversed a decades-long trend toward financial deregulation and fundamentally changed the face of the American financial system. Lehman failed and Merrill was sold to Bank of America (BAC). The government took effective control of AIG in an $85 billion bailout. And, in the biggest intervention of all, officials proposed to purchase the troubled mortgage assets of financial firms, a move that could cost hundreds of billions of additional dollars.

Meanwhile, worried investors sent the stock markets into a dizzying ride of huge gains and losses.

Here's how the events unfolded:

Friday, Sept. 12: The trading week ends with the fate of 158-year-old Lehman Brothers in grave doubt. Its stock had fallen sharply due to fears over its financial condition. Paulson, Bernanke, and New York Fed President Tim Geithner begin a series of meetings in Lower Manhattan with top bankers in an effort to engineer a bailout of Lehman, which had bet heavily in the subprime mortgage market. Two possible buyers emerge: Britain's Barclays (BCS) and Bank of America.

Saturday, Sept. 13: Talks on a possible Lehman buyout continue. The would-be rescuers look to the government to take on some of the risk, as it did in the shotgun sale of Bear Stearns to JPMorgan Chase (JPM) in March and the effective nationalization on Sept. 8 of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE). Government officials hold fast that there will be no federal bailout. Talks are inconclusive.

Sunday, Sept. 14: The negotiators continue meeting, facing a deadline to act before Asian markets open for Monday morning trading. But government officials insist there will be no federal backing of a Lehman rescue. With no help from Washington forthcoming, Barclays—the only possibility left after Bank of America leaves the table—withdraws. Lehman is done for. Meanwhile, Merrill Lynch CEO John Thain, seeing the writing on the wall, arranges the sale of his company to Bank of America for about $50 billion. In one day, the fates of two storied companies are sealed.

Monday, Sept. 15: Lehman Brothers Holdings, the bank's holding company, files for Chapter 11 bankruptcy protection and says it will try to sell key business units. Investor concern now turns to the fate of AIG, fearing a liquidity crisis. Rating agencies cut AIG's credit rating. Despite reassurances about the economy from Paulson and President George W. Bush, the stock market plummets. The Dow Jones industrial average drops more than 504 points, or 4.4%, the biggest loss since right after the September 11, 2001, terror attacks. The failure also roils overseas stocks, sending them plunging. Meanwhile, concerns about a slowing economy take oil below the psychological benchmark of $100 a barrel, its lowest level since February.

Tuesday, Sept. 16: The Federal Reserve meets and keeps the federal funds rate unchanged at 2%. Asian markets, some of which had been closed for a holiday on Monday, plummet. The Russian stock market goes into a tailspin, with the largest exchange down more than 17% before the Russian government halts trading. Managers of the Primary Fund, a supposedly supersafe money market fund, say that shares have fallen below the sacrosanct $1 valuation. Meanwhile, Goldman Sachs (GS) and Morgan Stanley (MS), the two remaining independent investment banks, report stronger-than-expected results. However, investors continue to beat down the companies' shares. Amid all the turbulence, U.S. officials decide that AIG is indeed "too big to fail." In a move that would have been unthinkable before the credit crisis began, the Fed arranges to lend $85 billion to AIG in exchange for a 79.9% equity stake. The deal is announced Tuesday evening. Even before the deal is finalized, the Dow reverses an earlier loss and gains 141 points.

Wednesday, Sept. 17: The government bailout of AIG fails to stem investor fears as they flee to safety. Credit markets tighten. The New York Times reports that Washington Mutual (WM), the nation's largest thrift, has put itself up for sale. The Dow plunges 449 points.

Thursday, Sept. 18: The New York Times reports that Morgan Stanley has "stepped up" merger talks with Wachovia (WB). The Fed moves to pump money into the financial system through lending programs operated by several overseas central banks and the Fed's own moves. At the same time, the government begins action on the hugest bailout of all, committing hundreds of billions of taxpayer dollars to buy troubled mortgage assets from beleaguered financial institutions. As word of the evolving plan spreads, stocks rally. The Dow closes up 410 points. In the evening, Paulson and Bernanke and Securities & Exchange Commission Chairman Christopher Cox go to the U.S. Capitol to brief lawmakers on the plan, which requires congressional authorization.

Friday, Sept. 19: The buyout plan—with few firm details—is announced and stocks soar worldwide. President Bush says the move puts "a significant amount of taxpayer dollars on the line," but he says the risk of not acting "would be far higher." In additional actions, the Treasury and Fed act to guarantee the assets of money-market funds, which had been threatened by the meltdown of the financial markets, and the SEC places a temporary ban on the short-selling of nearly 799 financial stocks. The Dow closes up 368.75 points, 45 points below where it was a week earlier but still 911 points over its bottom on Thursday morning.

A momentous week indeed, but there is no sign the economic drama will limit itself to a mere seven days. Lawmakers and regulators are to work through this weekend in an effort to devise bailout plan legislation that can come to a vote next week. The bipartisan consensus surrounding the deal can come undone as the details are ironed out. But for drama, it will be hard to match events that have reshaped the U.S. financial landscape for years, if not decades to come.