Okay so for months you’ve heard about subprime lending, people losing their homes, the housing market declining, banks firing their CEOs and writing off billions, and, basically, our economy taking a turn for the worst. so WHAT DOES IT ALL MEAN?!
This post will (attempt to) define subprime lending & the resulting “credit crisis.”
In a nutshell, since the housing market was up pepole wanted to buy homes because they thought the price of their home would continue to appreciate (increase in value). Mortgage lenders began doling out the mortgages to even those whose credit history was bad, or SUB PRIME, or who didn’t have the money to back themselves up. These subprime loans were too good to be true, with no money down and often very low interest rates for the first few years. What the lenders were duped (or allowed themselves to be duped) into was actually a loan that they would not be able to pay back, because in the later years those interest rates would rise to much higher rates. Indeed, the borrowers were unable to pay the loans back and they defaulted (when a debtor is unable to meet his financial obligations). The lenders then had to foreclose their houses (when a bank repossesses a house due to the owner’s failure to comply with the agreement, ie pay the mortgage) and the homeowners got screwed. Example, in Cleveland one in every ten homes is foreclosed.
So obviously that hurts individual homeowners (displaced from their homes), that hurts the mortgage lenders (did not receive mortgage payments from hundreds of borrowers), and that hurts the real estate market because there are a bunch of homes that can’t be sold (becasue people can’t get the loans they used to be able to get), or that are on the market for a much lower price.
What about Wall Street? Well, this is where it gets tricky. What happened in the middle of all of this was…… Wall Street (and by Wall Street I mean the big banks, think Merrill or Citi) either expanded its own mortgage arm to lend out those subprime loans, or they bought the mortgages from the mortgage lenders, acquiring all of the future repayments from the lenders as well as all of the risk. They then packaged up hundreds of those mortgages into a single security called a CDO (collateralized debt obligation - Which if you think about it makes sense. It’s a group of obligations from debtors (the borrowers) with collateral (their newly purchased homes) to back them up). They sold these CDOs to each other, and to hedge funds and other financial institutions for money. It’s like selling an IOU for $100 in the future to someone who will give you $90 today.
Okay, so with every kind of security (an investment instrument representing financial value) there are rating agencies (Moody’s or Standard & Poor’s) who rate the quality of the security. Well, the rating agencies gave the CDO’s high ratings, meaning there was little risk that the borrower would default. This provided impetus for the hedge funds to buy more CDOs. Everything was hunky dorey and both Wall Street and hedge funds were raking in the dough until the cookie began to crumble and everyone realized they were dealing with an investment instrument that lacked any financial value (you see, because the instrument depended on the mortgages from the individual borrowers who did not have the money to repay the loans). The whole system crashed, many hedge funds had to shut down, and Wall Street wrote off billions (and fired many).
STOP!!!!!!!!!!!!!!!!! That’s all you need to kow. For further reading, check out below (though I’ve been told it is too confusing, it goes into a bit more detail). Also, here is a link to an easy explanation.
What it is: Subprime lending basically means lending to people who have deficient credit history but who have collateral, like a house, to guarantee the loan. The interest schedule usually has low initial “teaser” rates (like no money down, no questions asked) that reset in later years to much higher rates. The borrower is typically unable to handle those higher rates and, basically, they’re set up to default (definition: when a debtor cannot meet his financial obligations).
Who lends & who receives: The borrower is someone with bad credit (from credit cards, previous loans, previous apartment rent), or who is in an adverse financial situation. The lenders are mortgage lenders.
How is the lending done: Subprime lending is through mortgages, car loans, credit cards, etc. Wall Street (think Citibank and Merrill Lynch) either makes these loans or steps in to buy those mortgages from the mortgage lenders. They repackage a hundreds of these loans into single CDO (collateralized debt obligation) packages. Then they sell them to hedge funds & other investors. The buyer of the CDO is given the right to both the cash inflows from the borrowers, and, of course, the risk.
Why does subprime lending happen: The recent boom in subprime lending was really a result of the housing boom – borrowers wanted homes because they bet on increasing house price appreciation, mortgage lenders wanted to lend them money to buy the homes. This is where it gets controversial. It is thought that it is unregulated predatory lending – the lenders are aware that the borrowers will not be able to repay the loans, which will lead to default, seizure of collateral, and foreclosure, as we saw this summer. Additionally, borrowers should have known better and were easily coerced.
Ahuh, ahuh, so what ACTUALLY happened:
What happened was the CDO’s (and thus the individual mortgages) that Wall Street were selling were given high credit ratings by rating agencies, who basically define the credit worthiness, or the borrower’s ability pay back the loan. This high rating encouraged hedge funds and other financial institutions to buy the CDO’s from the banks.
Basically, the whole system caught up with itself this year when a far greater than anticipated percent of borrowers defaulted and were unable to pay their loans. (didn’t see that one coming..)
Borrowers/homeowners - they can’t repay the loans, their assets were seized, their houses were foreclosed. In Cleveland, Ohio, one in ten homes is now vacant because of foreclosure. (definition of foreclosure: when a bank repossesses a house due to the owner’s failure to comply with the agreement, ie pay the mortgage)
Financial institutions –Wall Street bought the mortgages from the mortgage lenders or did their own lending. They turned around and sold off those mortgages in the form of CDO’s. Thus, they had more money for more lending, creating a snowball effect. They often sold off the CDO’s with an agreement to buy them back if there was no market to the buyer to turnaround and resell them. When the loans defaulted In the end the whole street wrote off billions and, of course, laid off many. Oh, and they put a cap on annual bonuses, at only $750,000 a year. Poor guys.
Hedge Funds – Since hedge funds bought into the fun little game, they, too, suffered losses. They bought the CDOs from the banks and then sold them to other financial institutions. Hedge funds also had repurchase agreements which say that the hedge fund will buy back the CDO at a later date for a greater amount of cash, basically protecting the buyer from default. Well, when the value of the CDO declined, the hedge funds didn’t have the cash or collateral to put up, the hedge fund was forced to liquidate their other assets. Many of them had to close down.
You, me, and our economy – That’s right. Now we’re looking at a recession.
I don’t have access to the same types of loans that I previously had, so I’m unable to spend as much money (especially during this holiday season when consumer spending is usually up up up). OR I saw the huge false demand for housing (false because it was being financed with money that nobody really had) which spurred me to enter the market and start building homes. Well now nobody is going to buy my homes and if they will, it will be for a much lower price than I anticipated. OR My home was foreclosed and I’ve been displaced. OR I live in a nice home in the suburbs that I thought was worth $500,000 and is not only worth $400,000. I feel a lot less rich and will likely curb my spending. OR I used to work for Merrill Lynch and I was laid off (unless I was the CEO, in which case I’m flying high) OR I worked/owned a hedge fund and got caught up in this mess and had to shut down/write off.
At least I think that’s what happened….